Mercer Advisors Capital Markets Update and Outlook: January 2021
Doug Fabian: Welcome, ladies and gentlemen. We’re going to get started in just a few seconds. Thank you for joining us today. Hello, and welcome to our first quarter 2021 Mercer Advisors Client Webinar. Today, we’re going to be discussing the latest developments in the economy and the financial markets. Now, it’s our goal with these broadcasts, to update you on the market’s progress, discuss economic developments and what you should be considering to improve your financial health in 2021. Thank you for joining us today. My name is Doug Fabian. I serve on the investment committee and I’m part of the client communications team here at Mercer Advisors. Notice the toolbar on your webinar screen.
There is a chat function that will allow you to submit questions. Please tell us what’s on your mind. We want to answer your questions about the markets, investment strategy and finance today. Now, joining me, is our Chief Investment Officer, Don Calcagni and Drew Kanale, one of our senior client advisors from Houston. Let’s get to our agenda. Today, we’re going to be talking about a recap of 2020. We’re going to be discussing our market outlook for 2021 and update you on economic statistics and then we’re going to discuss investment implications and then finally, get to your questions with our answers. Let’s kick this off with a look back on 2020. It was a year like no other.
Don, what are your thoughts on 2020 and what happened last year?
Don Calcagni: Yeah, I think I think you said it best, Doug. I mean 2020 was a year unlike any other it really just highlights how these unpredictable events frankly, can come out of nowhere and have really seismic impacts on the economy, market, society. I think through it all, when we step back and we actually look at the market as a whole in 2020, I think the lesson to take away is that markets are resilient. Markets are quick to process new information and ultimately over time, move on to new highs. If we just look at 2020, nobody this time last year or I should say very few people this time last year were predicting that we would have a global pandemic that would cripple the global economy to the magnitude that we’ve witnessed. So much so that believe it or not, in February, February 19th, the market hit an all-time high but between February 19th and March 23rd, we saw the most rapid bear market in market history.
It was the steepest sell-off. We had the largest one-day point drop for the Dow, the S&P, the Nasdaq. Interestingly, when we pivot and we look to Q2 in 2020, we also saw one of the best market returns in Q2 in over 20 years, since 1998. So, 2020 was really a tale of the worst of times and the best of times when at least we look at market returns. We saw the US economy contract about 33% in Q1 and Q2 and then it grew about 33% in Q3 and Q4, what that means if you do the simple arithmetic on that, the economy is still down about 9 or 10%. But when we look at 2020, we also had arguably the most venomous political season in American history and yet through it all, the market continued to march higher so much so that by the end of the year, Doug, the market had gone on to post new highs. The Dow had eclipsed 30,000 and that momentum also has now carried into 2021.
Drew, give us your perspective on what happened in 2020.
Drew Kanale: It I think Stephen King’s publisher would have rejected the story line for last year as is totally unplausible. As we went through the year, you look at this chart, the bad news was inversely related to what the market was up to. It’s almost like the worse the news got the better, the market moved. The takeaway, and Don’s going to share the slide with you later, so keep this in mind when we get to that slide, is the difference between ’08, ’09 and this experience, is liquidity, is the unbelievable liquidity that came into this system. There it shows up in the stock market and it shows up in home prices. I don’t think we have a slide for that. Again back to that, that tale of two cities that Dickinson can see but even Stephen King couldn’t have predicted this market.
Doug Fabian: My takeaway from this past year is market’s obviously unpredictable. And boy, throwing the baby out with the bathwater, making an emotional decision from a behavior perspective. One of the things that we’re constantly working on with clients is keeping them from making a bad decision when they’re stressed by news, headlines, price movement and staying the course really worked to our advantage in 2020. So, really important lesson. Don, let’s move on.
Don Calcagni: Yeah, Doug one more point. I’ll just double click on there for one moment just to remind our listeners. Coming into 2020, interest rates were already at historic lows, right. We had lots of investors asking, “Gee, why do I want to own investment grade bonds given rates are so low?” But by the end of March, I don’t think there was an investor in the world that did not wish that he or she had owned more investment grade high quality bonds because of the hedging characteristics that they provide when we see equity market volatility really spike. So, all great points. I think one of the bigger takeaways given we just came through this, like I said, very venomous political season is, I think we need to remind ourselves that markets do well over time regardless of which political party controls the White House or the congress, the senate or the house.
What we find is that over time, markets do well regardless of which party is in power. And, depending how you manipulate the statistics you can make an argument that maybe Republicans are “better for the market” or the Democrats are “better for the market.” I’m showing you data here since 1947. Interestingly, if you took this data series back to 1928, you’ll see that it actually flips where having a Democrat in the White House ultimately resulted in higher market returns over time. I think one of the big lessons here is, try to keep politics out of your portfolio, right. It’s great that we all have our own views but when it comes to investing, politics really don’t have a place in your portfolio. Doug, I think that was one of the key takeaways. Coming into last year, one of the questions we were getting was, “Don, what’s the average return on the market in presidential years?” Well, it’s about 10 or 11% depending on how you do the math. Last year, we saw that the S&P was up 18.4%. Despite everything that happened in 2020, despite a very poisonous political environment, the reality is that the market actually did exceptionally well despite all of that information.
Still mired in a very deep recession
Doug Fabian: Great. If we pivot and we start to look at the state of the world today, one of the things that we’re still struggling with is the economy is still mired in a very deep recession. The recession right now has shaved about 10% off of the US economy. Just to give our listeners a little bit of context, that’s about two and a half times worse than what we experienced from ’08-’09. If you think about it, the economy contracted about 30% in the first half of last year. That takes you down to about 70% on an annualized basis of where it was. And then from that base, we grew back another 30%. So, if you just take 0.7 and multiply that times 1.3, it’s going to get you around 0.9 or 0.91. That just goes to show that we’re still struggling we still have a ways to go before the US economy can recover fully from what we experienced in 2020.
Doug Fabian: Don, let me ask Drew. Drew, of the three of us, you’re the one that’s spending the most time with individual clients. What are the conversations from clients these days about the economy, the election? How are they feeling? What are your conversations like? Are people still trying to kind of override or worried about the future? Talk to us about that.
Drew Kanale: Obviously, the general atmosphere of 2020 was not a positive place to be. I mean, the best decision you could have made in 2020 was to turn the TV off, right. I mean, you were just you were just bombarded by negative information and so that tended to kind of bring your confirmation bias and anxiety up to high levels and it was the time to stand pat, to revisit your portfolio to make sure everything was in balance. You know the conversation we had more, I think people really appreciated, was the rebalancing aspect of the portfolio where you technically, sell your winners and buy your dogs. That really proved to be a good thing especially latter part of the year when undervalued stocks, small cap stocks all rebounded. I think a lot of clients started to see the logic behind diversification actually playing out for them despite what was being told to them in the media. I don’t care which channel you turned on. It was bad news all the way around. Not to say you shouldn’t have been concerned but we shouldn’t have taken our concerns too far in action against our plan. I’ll get back to plans later on.
Doug Fabian: I think the best takeaway you had there drew was just to reduce. We’re hearing stories about people, you know, I’m leaving social media. I’m not going to turn that on. Turning down the volume. Turning off the news. I just think you’re going to have a better life and a lot less stress. You can, ladies and gentlemen, you can take that as an action item from today, is just less. I’m not just saying go into the bunker. I’m just saying less in terms of those things. Turn on the Food Network. That’s what we have going on at my house a lot. So, Don, take us through…
Don Calcagni: Food is certainly less controversial.
Doug Fabian: Yes, it is.
Don Calcagni: Right. And certainly, so much more enjoyable, at least in my household. But all great, great points. As we step back and take a look at the economy, I think one of the things we also have to constantly keep our eyes on is inflation, right. Here we are, we’re dealing with the US central bank is in the process of candidly printing a lot of money to help support the US economy to help us get through this Covid pandemic. In theory, you would expect to see lots of inflation should that occur.
The reality is inflation at the moment remains a non-issue. That’s because the economy is still really way below, operating at a level that’s way below its productive capacity, right. When you have unemployment at 6 or 7%, when you have factories that are idle, when you have a lot of small businesses that are struggling, you’re just not going to see a ton of inflation right now.
Now, we’ll come back to this because we do think this is going to be a concern perhaps later in the year, certainly going into 2022 and 2023. That our view is this isn’t something that you get away with forever.We can delay dealing with inflation but ultimately, it will start to crop up in the economy.
One of the things I did just want to note here, Doug and Drew before we move on is that when we talk about inflation, we’re typically talking about headline inflation, which you see here at the top of this table that we have here on the slide and then we also have something called core CPI, that’s consumer price index. Lots of different ways to measure inflation. I think my message that I really want our listeners to take away from this is that keep in mind that all of us experience different levels of inflation.
If you’re a senior citizen and you’re for example, perhaps consuming lots of health care services, the inflation rate that they experience is going to be different than say somebody who’s middle-aged and who perhaps is not experiencing lots of inflation and consuming lots of health care services. I have a teenager who’s getting ready to go away to college so I’m starting to experience all of the education related inflation with respect to tuition. We all experience different levels of inflation. What we’re just showing you here is the average inflation rate across the entire economy.
Planning for inflation
Doug Fabian: Don, two points on that. Number one, all of our advisors and the advisors to the audience, your advisor is putting an inflation number into your financial plan. That could be 2%, that could be 3%, that could be 3.5%. You should have that conversation. And then to you, Drew, I think that looking at what hedges against inflation, stocks have been a great inflation hedge historically. That’s something we want to remind people about.
Drew Kanale: Correct. And whenever we do planning scenarios we show clients different inflation environments so they get a feel for the sensitivity of their retirement plan against of cost of living that isn’t necessarily predictable in the long range. So, they they’re informed, right. There’s an expectation about if we did get into a high inflation environment, what would their plan look like?
So, we see both. Last year was particularly a deflationary year especially when you put the energy component in there. I mean, recall that back in March, energy traded negative. They would pay you to take natural gas away. They would pay you to take crude oil away. So, we’re coming off that average price, right, and current, let’s just say administration leanings are not going to lean towards increased supply of oil, which probably puts pressure on energy prices to be higher in the future which is going to show up in these inflation numbers and it’s going to show up in your check book. Because you’re going to see the difference between two-dollar gasoline and wherever it ends up landing depending upon the slope of our growth rate going out. Kind of one more point there. Aviation travel’s down, let’s just say 50%. When demand for jet fuel starts to increase as we all start moving about again, that’s going to put pressure on energy prices. So, those numbers are going to move in the next 18, 24 months, for sure.
Doug Fabian: Great point.
Don Calcagni: Drew mentioned a point that I want to double click on for one moment here. In April and May of last year, the US economy was in a deflationary downward spiral, all right. We saw that with the collapse in energy prices, collapse in lots of other prices throughout the economy and that’s because the economy was shutting down to combat Covid. That is why by the way, the federal reserve has pumped so much liquidity into the US and frankly the global financial system, was to combat that downward deflationary spiral. I would argue they’ve been largely successful because at least our headline inflation, is still… It’s positive. We have not experienced serious downward deflation thanks in part to the quantitative easing that the federal reserve has initiated.
Doug Fabian: I just want to remind the audience that the chat function is available for your questions. If you have a question, please put it into the chat function that’s in that toolbar on your screen and we’re going to get to your questions in not too long from now. Don.
Global equity and bond markets
Don Calcagni: Just to recap what global equity and bond markets did last year if you look at this this sort of elongated bluish turquoise box on your screen. We’re showing you here equity market returns around the world. So, in the United States, the US stock market I referenced earlier was positive 18.4%. Now, there’s a little bit of a story within that that we’ll get to here in a moment. When we look outside of the United States, we have this thing called the All Country World Index, minus the US we have EUFA that stands for Europe Australasia and far east. When we look globally, we actually saw really healthy equity market returns. Globally emerging markets, which frankly have really struggled over the past I’ll say 10 or 15 years, clocked a nice 18.7%, was actually the best performing major equity asset class for all of 2020.
With respect to bonds, I remember when we had this capital markets update last year, we were telling everybody not to expect great things from bonds in 2020. Now, that was certainly in our defense, before Covid. But by any objective measure, and I referenced this earlier, bonds had a phenomenal year because interest rates went still lower as the US central bank brought interest rates down to zero and pumped a lot of cash into the system. That was a very powerful tailwind for bonds across the board. You’ll see here with respect to US treasury bonds, arguably the sleepiest corner of the bond market, the 30-year treasury was up 18.7%. That is just absolutely staggering when we look at the historical returns for the 30-year bond. So, just an amazing tailwind for bonds. By the way, that was pretty much across the board. We look at municipal bonds. Municipal bonds had a good year but not as good as we might have expected because there was certainly a lot of concern among municipal bond investors that state budgets were in trouble. I would argue they are in trouble, right.
You look at New York for example, dealing with a 15-billion-dollar budget deficit and that’s really related to the impact of Covid. So, munis this year may be a better year. We’ll see depending on what happens with the rescue package that’s being put together. But the important point here is that not all bonds are created equal. When we look inside the US equity market, there’s a story here, right. The market was up 18.4% last year. Last year saw very, very narrow market leadership. What I mean by that is by the end of September, there were only five stocks in the S&P 500 Index that accounted for all of the positive returns on the index as of September 30th. The other 495 stocks as a whole were collectively negative or flat for the entire year, all right. When we look at…
Drew Kanale: So, it’s 5 versus 495, right.
Don Calcagni: Correct.
Drew Kanale: Bears repeating.
Don Calcagni: Absolutely, right. Five stocks by the end of September accounted for the entire positive gain on the Standard & Poor’s 500 Index versus the bottom 495. So, if you didn’t own those five stocks in precisely the same weights as the market, if you were underweight those at all, you had a slightly lower return than the market, right. So, interesting. This is the point I want to make, right. This is why we are diversified investors. By the end of the third quarter of last year, small cap and value stocks by far were the absolute worst performers, right. When I was talking to clients and prospective clients at the end of Q3 and I was telling them to own small caps and to own value stocks, they looked at me like I had a third eye growing out of my forehead, right. The reason why we diversify is because returns within sectors and across factors are random, right.
We always see mean reversion over time. So, when we look at Q4, we saw that that actually flipped quite dramatically, where value and small cap stocks by the end of the fourth quarter by far were the absolute best performers. That momentum has actually continued into the early part of this year where small cap in value stocks, at least at the time we put this together, were in the lead. Right now, there’s a bit of a tug of war between which sector and which factor is going to lead the market but that momentum sustained itself into 2021. And, back to Drew’s point earlier, it’s those value stocks that ultimately, the market pivoted away from the more expensive growth stocks and into these cheaper less expensive stocks and smaller stocks.
Makeup of value
Doug Fabian: Drew, talk to us a little bit just about the makeup of value. Obviously energy, a big opponent. How are you having those discussions with clients? Obviously, most Mercer Advisor portfolios following the factor model are tilted towards value. So, give us a little color around value in general.
Drew Kanale: Well, just to remind everybody. Value stocks by definition, trade against book value. It’s the book value of the underlying security against the market value. It’s over — academically speaking — over the long-term, they always outperform. We’ve been in a period where we’re going 11 maybe even 12 years where they’ve underperformed the growth or momentum component of the market. The ilk, the type of stock presently value is energy, banking, hospitality, all those kinds of names that are just really out of favor of hospitality and travel, they’re still going to struggle for a while but not forever, right. Banking’s been struggling but that’s been a function of the yield curve and the spread they can achieve on lending and the yield curve’s getting a little steeper. You saw bank stocks really take off towards the end of the year so value was coming back into the favor. Now, there’s two sides to this story, right.
You not only buy value stocks because they’re undervalued, the rotation Don’s describing but you’re doing it because the growth and momentum stocks are stratospheric in their price to earnings multiple, almost to the point where they’re pricing in perfection on the outcome five years out from now, right. I’m really talking about an arc of time here. This is what’s happening. I always felt good about kind of this market when I had discussions because at least decisions were being made. They were making some relative decision about momentum and growth over value. It wasn’t just sell everything and head to the barn, right. It was a conscious decision. It may not have been the right decision but it was an orderly market about making its decision. Same thing was true in the last half of the year. An orderly rotation that made sense. It wasn’t just we got a vaccine, although that certainly is a big deal. The execution of the vaccine this year is a very big deal. If you’re in hospitality and entertainment, you are really betting on this vaccine. That was just kind of the — how it really ended up playing out and it’s very orderly in fact.
Don Calcagni: I would add to that energy is the best performing sector so far year to date, followed by consumer discretionary, classic value sectors at the moment. There’s also tend to be sectors that as the economy begins to recover, we should see a broadening of market leadership. So, we should see energy, we should see consumer discretionaries. Those sectors especially, should really do well as the economy begins to expand again. That’s probably a good jumping off point, Doug, where we should pivot and look forward to 2021.
Dominate themes of 2021
Don Calcagni: What are the dominant themes, the tailwinds the headwinds and so on and so forth? I think the dominant themes coming into 2021 are really what we were just discussing. There are huge expectations that the economy is going to recover. Like Drew said, we have not one but we have two viable vaccines. The new administration is working hard to distribute those and that’s really going to drive in our view, how the market, how the equity market is going to perform going forward because that naturally has huge implications for any recovery in economic growth. In terms of the tailwinds, you have a new administration that’s very open to fiscal stimulus.
I would argue that tax increases are off the table. I actually think that’s a tailwind because you have such a divided congress that the prospect of actually getting any major tax changes through congress seems very unlikely at the moment. You have low rates. From a forecasting perspective, we think that earnings are going to recover quite handsomely here by mid-year and late year. That’s a powerful tailwind for equity markets as a whole. Now, in terms of the headwinds, there are certainly a lot of things that could go wrong. What we could see is we could see new strains of Covid, right. We’re already hearing about that. It still remains to be seen how effective are the vaccines that we have against those strains. I’m not an expert in those areas so I obviously can’t comment on that but ultimately, those are the sort of headwinds we have to pay attention to. How effective is the new administration going to be with respect to vaccine distribution?
They’ve got some big goals and I think that’s great but if we do run into supply chain problems or distribution problems with respect to the Covid vaccines, those could be major headwinds for 2021. In terms of another headwind that I think is at least out there that bears mentioning, is that we’re already seeing a little bit of inflationary pressure in my view, showing up in fixed income markets. The 10-year’s up about 12 basis points so far this year. The 30-year treasury bond is up about 15 basis points so far this year. Is that anything to get really alarmed about? No. It’s just something I think we have to pay attention to, that we really could see some curve steepening of the yield curve for bonds throughout 2021. The point being is that the federal reserve controls, I should say, influences short-term interest rates. The fed actually has very little, if any control over longer term interest rates.
So, even while the federal reserve has said — Hey, we’re not going to raise interest rates until 2023. The reality is the market can actually raise rates on its own effectively in the secondary market for longer dated bonds. I do think that’s a risk. I think it’s out there. There’s certainly lots of other risks. We have very lofty earnings growth estimates. When I say we, I mean Wall Street analysts. The consensus estimate that we should expect about 22% earnings growth in 2021 for S&P 500 Index companies. That is a very rosy number. If that number comes under stress, that obviously could be a major headwind for the market. In terms of investment implications, I already touched on energy. Energy is the best performer this year. It was the worst performer by far last year but this year looks like it’s gearing up to be the best performer.
In terms of investment implications, right, when we look at the economy, we’re expecting this road to recovery. We’re expecting broader market participation. Equities have a really powerful tailwind but there are concerns around valuations. That’s why we think from an equity perspective — and like Doug and Drew have already commented, our portfolios are always pivoting and tilting and overweighting value relative to those more expensive growth stocks. We’re already doing that for you. It’s not like it’s something you have to do. It’s something that we do proactively as part of our investment philosophy in the way that we manage portfolios. So, value stocks, small cap stocks should come into play. We’re already seeing that. I showed you that rotation in Q4 and how that has continued to manifest itself this year.
But as the economy continues to recover, we should see broader market participation. The final thing here on equities that I’ll highlight — we’re going to walk you through some data here in a moment — is really non-US stocks. Certainly, as the US federal reserve continues to expand the money supply, what we should expect is the dollar to weaken and that is a nice tailwind for non-US investors. On the bond side, from a portfolio management perspective, in the event that that curve does steepen like I was mentioning a moment ago, you want the bonds in your portfolio to be shorter term bonds. Longer-term bonds get hurt the most when rates rise. Shorter term bonds get hurt the least when rates rise. So, in the portfolio, we want to be shorter duration meaning the effective maturity in the portfolio. You want those bonds to mature sooner rather than later.
Concerns about taxation
Doug Fabian: Don, before you take off to the next slide there. Just, Drew, just getting your comments on discussions with clients. Obviously, many times in a conversation with clients, they’re bringing their concerns forward to you. What are you hearing right now? How are you navigating through that conversation with clients?
Drew Kanale: They’re very concerned, as Don touched upon, taxation. They’re concerned about their estate planning. They’re concerned about their marginal tax rate. It’s bears discussing — Would the qualified dividend be a target for taxation? Presently, they are all going to be discussed. You’re going to hear about them on television. There probably will be proposed legislation, maybe not soon but maybe closer to year two, right, because there’s midterms, right.
Doug Fabian: Sure.
Drew Kanale: But at some point, it’s going to come up. Under the present structure of the house and senate, it’s highly unlikely. It’s highly unlikely they’re going to be successful but it doesn’t mean they’re not going to discuss it and give people concerns about it. It is something we want to pay attention to because the market will discount the present value of those earnings streams on an after-tax basis, no doubt about it. So, it bears watching. That’s not an immediate headwind but it’s one you want to have on your radar and it’s one thing clients definitely are talking about.
Doug Fabian: Well, that’s one of the things that we’re doing being wealth managers, is having those tax conversations with clients. Taxes are, you know, certainly we have current year, current situation but we’re also monitoring a client’s balance sheet and helping clients with decisions when assets should be sold. And then we’re going to also be paying attention to any tax law changes. Of course, clients have been seeing us respond to those in the past and we’ll continue to do that going forward. So, thank you, Drew. Don.
Don Calcagni: Yeah. I want to add to what Drew said I think tax policy is always a consideration. What I would say to that is my personal view is and I’ve shared this with listeners many times in the past, is that longer term, taxes will rise. Given the national debt, given the structure of our workforce, it just logically follows that taxes will rise if we expect our government to continue to provide just its current level of services to its citizens. If that increases, then naturally, those dollars need to come from somewhere. I think it’s a when not an if. But I do agree with you, I think getting it through congress right now is going to be exceptionally difficult given you basically have a 50-50 split with the vice president of course, being the tiebreaker in the senate. Just seems very unlikely that a Lisa Murkowski or a Senator Manchin from West Virginia, just doesn’t seem likely that they’re going to be on board with major tax changes.
As we look within the market, when we look at broad market valuations, right, this is a key thing. This is one of the bigger risks coming into 2021. I mean, the great thing about 2020 is the market digested some really ugly news, still went on to post good returns. The reality is we need the earnings to catch up, right. Prices have grown but we need the earnings to catch up. Right now, when we look at the market, meaning the S&P 500 Index is trading at about a little over 22 times next year’s earnings. That’s high. That’s almost — not quite but almost as high as it was during the late 90s.
There’s a big difference between then and now.
In the late 90s, the market was propped up by dot coms that had no earnings. The difference today is we actually have companies that have earnings. When we actually look at earnings estimates, which we’ll get to here in a moment, if earnings growth manifests itself to the tune of 22% and even if the market is flat for the year, that’s going to bring the overall value of the market back down. Because again, we’re looking at market value in this particular context in terms of price to earnings.
As Drew mentioned earlier, there’s lots of ways to look at value. He referenced price to book, which he’s right, academically, has the most predictive power when it comes to returns. But here, we’re just talking about earnings just to keep the conversation relatively simple. But again, this is a risk. It’s a risk if you are overly concentrated in for example, these big high-flying technology type names, Facebook, Amazon, Apple, Netflix, right, because while the market as a whole is trading perhaps around 22 times earnings, the reality is you have some really big high flyers.
I mean, look at Amazon. Great company. Has changed our lives, it’s certainly changed my life in a big way trade. Amazon trading at almost 94 times earnings. Netflix — love Netflix but at 86 times earnings, these companies are trading at stratospheric valuations relative to their current earnings. Now, like I said a moment ago, their earnings are growing, these are classic growth companies. They’re doing well. Their earnings have to continue to grow in order to justify those lofty valuations.
One of the ways to think about markets, it’s not about whether or not something is good or something is bad. That’s not the right way to think about it. You always need to think about the rate of change. Is something better or worse than it was previously? When you’re looking at growth, when you’re looking at earnings, when you’re looking at economic activity, you always got to be asking yourself — Okay, is this better or worse than what we expected prior to having this new information? The question remains to be seen, will these companies continue to grow and at the pace that they have grown at historically? Little known fact, I mean, if you look at Microsoft stock. For nearly two decades, since 2000, Microsoft stock had a poor return for its shareholders. Great company but a really poor return. Part of that was because its valuation in the late 1990s and early 2000s was at nosebleed levels and it took the company a long time to recover. What you’re looking at on the screen here is I just want to highlight this gray area is showing you the spread around the average. The point here, is not all stocks are equal in terms of valuations.
Drew Kanale: Yeah, Don, one more point about ’99 versus today is interest rates and how it figures in the present value calculation for valuation is a big difference. When you’ve got a 5, 6% six treasury versus a 1% treasury on the average investor’s perception of value, they’re willing to pay a premium. Now, I’m not going to put an infinite sign next to it when you get interest rates really low or negative like they are in Germany but it is one thing that is materially different than the last time we got to this overall market valuation level, our interest rates. Again, our feeling is the current administration, the next fed governors, they’re going to keep interest rates right where they are at least for the next two years, no doubt about it. They’re going to keep the liquidity in the system. So, the market can sustain these valuations but I’m with Don. I sure would like to see some earnings to confirm these valuations if not compress them a little bit.
Don Calcagni: Absolutely. Drew nailed it. I mean ultimately, interest rates have a huge impact, significant impact on valuations when financial analysts are looking at ultimately, pricing or valuing any asset, it’s always a function of interest rates. To Drew’s point here with respect to earnings, these three blue bars that you see on the far right hand of your screen, those are analyst estimates for S&P 500 Index companies. You’ll see we were projecting a healthy recovery in earnings. Now, when we actually look under the hood, those earnings forecasts are really predicated on a big assumption and that is that we can get Covid under control. If we can’t get Covid under control, if we have some issues with respect to vaccine distribution or vaccine acceptance, you know, there’s some folks who don’t want to take the vaccine — things like that could be a headwind for ultimately seeing the economy and subsequently, earnings recovering.
Doug Fabian: I’m watching the time here gentlemen. Yeah, just watching the time there, Don. We want to get to some questions. Go right ahead.
Don Calcagni: Absolutely. I think the last point I’ll just touch on here. We’re talking about valuations, right. If you care about valuations, you should really care about owning non-US stocks. Folks always come to me and say, “Well, Don, they didn’t do really well over the past decade.” That’s exactly why they are a good value, is that the prices are cheap relative to their earnings. When we look outside the United States, non-US stocks are trading at as much as a 25% discount relative to their US counterparts. When we look outside the US, you’ll see that non-US stocks are trading at only about 16.7 times earnings versus 22 times earnings for US stocks. Definitely a healthy value there. I already referenced earlier the headwinds that the US dollar is going to be facing as we continue to expand the money supply. The federal reserve has embarked on a pretty aggressive quantitative easing program. We saw that last year.
The US dollar was down about 7 or 8% or for the past year or so. So far this year, it’s pretty much flat to slightly positive but that’s a powerful tailwind for non-US investors when we see the value of the dollar start to creep down relative to non-US currencies. I think the other thing I would just highlight is look and we saw this with value and small cap last year. No one asset class will continue to grow to infinity and beyond. We see rotations, we see reversions to the mean. We saw that with small, we saw that with value. We will see that with US and non-US stock performance again. There’s always been a tug of war between these two broad asset classes. It is unrealistic to think that US stocks will continue to constantly outperform their non-US counterparts. For those reasons, we advocate having a globally diversified portfolio rather than just investing in one country for example, the United States.
Doug, I think these are kind of the key takeaways and then we’ll pivot to questions. We already highlighted markets have done well under both parties. Let’s keep politics out of the portfolio. Big policy changes. Drew and I just touched on this. Probably off the table. The only exception to that would be perhaps big tech. Neither political party is happy with the state of big tech. There could be some anti-trust momentum coming out of this congress. We have strong tailwinds for equities right now. What that means is investors should just focus on broad asset class exposure rather than trying to look for taking a concentrated bet on a big winner, trying to look for the next high-flyer. You don’t need to do that. You don’t need to do that. Equities have a strong tailwind already. We just advocate — take broad exposure to the asset class. Keep an eye on valuations and duration, minimize the exposure to big tech.
Doug, these are things we already do for our clients but it is something that really drives how we think about portfolio construction these days given the tailwinds and the headwinds that we see in the market. My final point is you always have to have a plan, right. You want to have a plan in place before you need it, right. You always want a crisis plan in place before you need it but you should always have a financial plan. Review it often and take the long view. I think when we look at 2020, that’s the key takeaway from 2020. Is — take the long view. Have a plan meet with your trusted advisor. Review it often and just keep an eye on the long term. Doug.
Valuations, should we be taking some money off the table?
Doug Fabian: Drew, I want to go to you first. A number of clients are asking a question around valuation and some are couching the question — should we be taking some money off the table here? They’re wanting to know whether or not we’re in a bubble. How would you be addressing the valuation level and our strategies, how we’re implementing our strategies, how would you talk about that with clients?
Drew Kanale: I touched upon it earlier. It’s always difficult to sell your winners. You’ve danced with who-brung-ya. We’ve had this really nice run and growth and momentum and you haven’t seen great returns out of value. When you get into valuations of small cap evaluations of international stocks on the value side, they’ve been really underperformers the last couple years. Well, it’s the time to do that rebalancing of the portfolio. We do it but for clients that have other holdings out there that are wondering is this the time for me to diversify out of this big Amazon position I have, look at the valuations. I may not be right this year but I’m going to be right eventually. There’s going to be a regression to the mean. You don’t have to sell it all but you can begin to chip away at that and buy the cheaper stocks.
That’s the simple way to do this. You should talk to your advisor if you’ve got concerns that want to make you move off plan, okay. We all know what I’m talking about when I say move off plan, change your allocation, right. If you really feel strongly about that, you need to talk to your advisor about what it would take to keep you at that allocation, what it would take to keep you on plan. Where’s your comfort level such that you don’t make the big decision by going all to cash, right, that some folks did last year. What is it that you can do to revisit your plan, get back to home base and make sure you stay on that track. But mostly, it’s a question of rotating within the portfolio to pick up the cheaper valuations.
Doug Fabian: Don, to you, with the way that you have as our Chief Investment Officer, you’re designing portfolios, you’re working with the investment team. Here we have high valuations, certainly, there’s some portions of the market that are much more overvalued than others. But just talk to us for a moment just about our strategy and how we’re compensating for not being all large cap tech. We have new clients on the webinar here. Just talk about what we’re doing just as a matter of course so they’re understanding it from your point of view.
Don Calcagni: Yeah, there’s really three things there, Doug, that I’ll highlight.
- One is when you look inside of our portfolios, when you look at the managers that we hire to execute each mandate within our diversified portfolios, those managers have sector caps in place. When we actually look at the more overvalued sectors in the market, it’s going to be the usual suspects, right. It’s going to be your technology and things like that. Those firms typically — actually almost all of them have sector caps in place to really avoid the portfolio from becoming overly lopsided and becoming a really heavy sector bet. That’s one thing.
- There’s really two levels of rebalancing that occurs inside of our portfolios. There’s what we do at a portfolio level where we will shave off momentum stocks. We still have exposure to technology and things like that through our momentum allocations but we rebalance. We’ll shave that off and then we’ll reallocate that to the value…the lower, the less expensive components of the portfolio. That’s the rebalancing at the portfolio level.
- There’s also rebalancing inside each of the sleeves, whether it’s an ETF mutual fund or separate account manager in the portfolio. Those strategies typically rebalance monthly. There’s a few that rebalance every six months but they’re constantly re-ranking their portfolios every month going back, removing the winners and then going and — to use Drew’s language — they’re buying the dogs, right, the dogs of the Dow strategy, right.
You’ve got multiple levels of rebalancing that occurs inside the portfolio plus having these constraints in place to avoid the portfolio from becoming really, just a fancy sector bet which frankly, could really hurt clients if we didn’t do that. That’s how we’re doing that, Doug. We’re constantly rebalancing, constantly shifting both at the portfolio level but also inside the underlying sleeves in the portfolio.
How we manage money within fixed income?
Doug Fabian: A number of questions here on fixed income and how we manage money within fixed income. Drew, one of the basic questions here is — what is short duration, what do we mean by short duration? And then in a rising interest rate environment where we’re seeing short-term interest rates rise because the economy’s recovering, things are getting better, what do we do with that fixed income sleeve, how do we continue to make money for clients there? Just address the concerns, short-term rising rates. What are we doing with fixed income, how do we do it differently than other portfolio managers? Drew.
Drew Kanale: Yeah. The traditional fixed income strategy is what they call a ladder, right. You have securities maturing in one year going out to say 15 and 20 years and it kind of resembles a ladder going out. In that way, you’re kind of ensured of enjoying the best possible coupon at the most reasonable risk. Today, the average duration of a port… Those portfolios might have had durations of 10-12 years, okay, for the average investor. Today, if you’re talking about a short-term duration portfolio, you’re talking about five years. It’s a combination of the coupon and the average maturity brings your total exposure down to about five years. What’s the magic number about that? Well, it ensures you get some type of coupon return depending on whether you’re using corporate bonds or municipal bonds.
At the same time, if we have a move in interest rates to the upside, you’ve got the bulk of your money coming back to you within five years and you can reinvest at those higher rates. Having begun my career in the high inflation days, a lot of the clients I’m working with weren’t around back in those days of double-digit inflation and it was a very different world, I assure you. It puts our experience are biased on being wary of rising interest rates because it’s just devastating to a portfolio when fixed income is your typical cushion against bad stock markets. You still have that fixed income component that doesn’t quite have the volatility. Well, these interest rates, right, Don, at these interest rates, you could see 10, 15% losses on paper and fixed income like that because you’re moving from such low rates.
So, if the 10-year goes from 1-2%, it’s going to be a really bloody market action. Who knows how much leverage is in this market in terms of margin or extended hedge funds that are using this cheap money to bolster their portfolios. That’s kind of one of the reasons why you see valuations where they are. You want to have a shorter duration in my opinion, because the risk-reward, I don’t know how many years you’re going to have where the 10-year goes from almost 2% to 1, to give you those outsized returns. I’m really thinking at some point, inflation does show back up. Markets start making decisions outside of central banks and the yield curve takes some type of normal relationship to cost of funds and inflation.
Doug Fabian: Don, comment too on what Drew said but also talk — questions about municipal bonds. We have a lot of clients’ taxable portfolios owning munis. There’s stress in the muni market because of tax revenue. If you would layer a comment in there as well as commenting on what drew said on how we manage money to manage risk in rising interest rates
Don Calcagni: For sure. Just to echo what Drew said, I mean, our portfolios are typically laddered. How Drew was explaining we have parts of the portfolios maturing in different years for example so that it’s laddered out. Drew’s a 1,000% right. That’s how you hedge or at least immunize your portfolio to a large degree against future rate hikes. Our typical fixed income portfolio right now has an average effective duration of around three to four years. If you look at the broad market, the Barclays aggregate for a moment, that’s basically the S&P for the bond market for those who aren’t familiar with it, the duration for the Barclays Agg at the moment is right around 6 years, I think, last time I checked. So, our durations are 40-50% less than the broader market.
That’s a sign of our conservatism within the fixed income portfolio. Part of that’s because there’s better places to spend your risk. When we build a portfolio, Doug, we look at it through a risk budgeting lens and we ask ourselves — Where do we want to spend the risk in the portfolio? Well, you want to spend it where you’re going to get the highest return expectation. That’s in value stocks and small cap stocks and things like that and emerging market stocks. That’s how we think about it. We think about it both as its own sleeve but then how it fits within a broader portfolio as well. With respect to municipal bonds, obviously, states are really struggling right now because of the impacts of Covid. It tends to be the larger more popular states. I mean, when you have a pandemic, it logically follows that it impacts population.
So, those states that have the largest populations or more people per mile that are going to feel the impact especially, the economic impact. You’re also seeing a flight, right. I mean, prior to Covid, I worked in Denver and Philadelphia. Now, I’m out in the country and I’m not no longer paying wage taxes to the City of Philadelphia or to Denver. So, those states are really hurting from this whole work from home movement. This is where I think the rescue plan that the new administration is putting together, there’s a couple hundred billion dollars in that plan to support these states to help them get through this Covid inspired pandemic. I think the market is expecting that aid to get passed. The reason I say that is when you look at muni bond returns just for the month of January, you’ve actually seen yields come down for muni bonds, about six or seven basis points. I think the market is expecting some support there. I don’t think we see any defaults. I mean, I’ve written on this in the past.
There really is no bankruptcy mechanism for a state to file bankruptcy. And I would argue that even if there were, I mean, the whole premise behind bankruptcy law is that you are somehow insolvent, right. It’s hard to see how the state of New York which owns millions of acres of land is somehow suddenly insolvent. I don’t buy the argument that they’re going to default. I do think if they don’t get aid from the federal government, it could put some pressure on muni bonds. But at the immediate moment, I don’t see a problem in the muni market. It’s something, Doug, that we have to watch, we have to pay attention to and we’ll ultimately, see what kind of support the states get.
What I would say is last fall, in early October, we added a new strategy, a new fund to our muni bond portfolios. That’s the DFA selective state municipal bond fund. The whole idea behind that particular fund is to be more selective around which state’s debt we add to the portfolio. It’s not meant to explicitly avoid states like California and New York but it’s underweighting typically, what you’ll find in terms of a traditional index, a muni index type portfolio. We are being very conscientious about how we allocate within the muni space and just trying to make sure we keep a close eye on the risks in that asset class.
Financial health in 2021
Doug Fabian: Gentlemen, we’re bumping up against the top of the hour. One of the things that we promised listeners today is — let’s just talk for a moment about their financial health in 2021. Ladies and gentlemen, we view our relationship with you as a partnership. We’re working together to improve your financial health. In that context, Drew, in the conversations that you’re having with clients right now, what would you be advising them — Hey, here’s something that you should consciously be doing or we should be working together to do for your family in 2021. What comes to mind? What’s at the top of your list?
Drew Kanale: Yeah. It’s — revisit your plan. Go back to your base plan. Make sure that the plan you put in place 5 years, 10 years ago is still valid. You understand the assumptions. It’s meeting your goals. Maybe some of your goals and objectives have changed. Maybe you’re just concerned about the market and you want to test that plan against a black swan event, against an exogenous shock and you can do that. You can run through that plan again and do some scenarios, a little higher inflation perhaps, and revisit the plan such that you have an expectation about what your plan may look like under different scenarios and are you comfortable with that. That’d be my number one thing to do for ’21 because there’s too many unknowns about legislation and necessarily where earnings are going to go. So, know what you can control and it’s in your plan.
Doug Fabian: Before I go to you, Don, Drew let me comment on one thing. Investors have a tendency to be looking at the scoreboard constantly with their portfolios. As you just laid out, we’re going to look at 2021 and what the cash flow needs are of a family but we’re also going to be cognizant of when those cash flow needs are going to change i.e. retirement. If that’s on the horizon, we want to be thinking about the investment portfolio and when we’re going to turn on the income stream. So, it is this cash flow discussion. We’re going to have this bumpy ride. It’s not always going to be a smooth ride and 2020 was an example of a bumpy ride. We don’t like a bumpy ride on an airplane but we have to realize that that’s just part of air travel sometimes.
The pilot’s always looking for that calm air to be able to get us there safely and a good experience and that’s what we’re attempting to do as we’re working with clients. If you have a cash flow need that is going to be outsized in this next year, that’s something you’re having a conversation with your client about. But if the client does not need cash flow from the portfolio for five years, we have to coach them with — Hey, there’s going to be some rough water. We don’t need this cash today. Let’s stick with the plan. Let’s get the returns that we expect from equities as opposed to trying to dance around things because of some short-term opinion about the markets. Don, let me go to you with your comments on — Hey, what are we doing for investors to improve their financial health on 2021 and what advice do you have for our clients?
Don Calcagni: I think it’s important, Doug, to always remember that the future will look different than the past. I think that that is never more true than it is today. What I mean by that is you need to be careful driving your portfolio looking in the rear view mirror. I know as investors, as humans we have we have a propensity to do that. We’re always looking at, to Drew’s point or what you said, they’re always looking at the scoreboard, right. The challenge is the scoreboard doesn’t always tell you what you think it tells you. And then number two is that the scores on the scoreboard can change quite dramatically. Again, we saw that in Q3, Q4 with that rotation into value and small cap. My message to investors is one — have a plan. The plan should ultimately inform what your portfolio needs to look like. Investing is a means to an end. It’s not a spectator sport. It’s a means to an end.
The only thing that really matters is the degree to which your portfolio is bringing you ultimately closer to what it is you’re trying to accomplish. But if you yourself are not clear on what it is you’re trying to accomplish, then frankly, you have no idea what your portfolio should look like. You should always begin with the end in mind. Number one — keep in mind the future will look different than the past. Number two — keep the end in mind. Number three — from a portfolio perspective, just to get really tangible for a second here, diversification, risk management is really the story here. The fact that we don’t know the future, the future is always uncertain. There could be a breakup of big technology companies. There could be some serious inflation that returns. There could be a lot of things that could really impact markets going forward.
The best way to deal with those is have a plan in place that has a crisis plan built into it so you know what to do when and if a crisis occurs. And keep your portfolio extremely well diversified. Make sure you have a healthy allocation to fixed income. Meet with your advisor. Make sure your portfolio represents/reflects your tolerance for risk. Those are the things that you control and then frankly, you should ignore the things you can’t control. None of us can control what happens in Washington DC. None of us can control what happens in global financial markets but we can control the degree of diversification in our portfolio. We can control whether or not we have a financial plan in place and we can control whether or not we let our emotions influence how we manage our portfolios. That would be my message to our audience.
Doug Fabian: Well, great. Gentlemen, thank you. Ladies and gentlemen, we appreciate your patronage. We encourage you to have conversations with your advisors. We’re going to continue to bring you these broadcasts every quarter to keep you up to date with things. If you didn’t get your question answered today, we encourage you to reach out to your advisor to have that conversation so you do get the answers to your questions. We appreciate you being clients of Mercer Advisors. That concludes our broadcast today, ladies and gentlemen. Have a great day. We’re going to make it a great year and we’re looking forward to working with you long into the future. Have a great day.
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