Doug Fabian: Welcome to our quarterly Mercer Advisors Client Conference Call on the Investment Markets. We appreciate you taking time out of your busy schedule to join this event. The purpose of this call is to provide you with an update on the financial market’s progress so far in 2018. Along with that market information we will be discussing key economic drivers and answering your questions. My name is Doug Fabian and I will be facilitating today’s event. I am the Science of Economic Freedom Podcast Host, and part of the Client Communications Team here at Mercer Advisors. Joining me is Don Calcagni, our Chief Investment Officer and leader of our 14-member Investment Committee, and Drew Kanaly, Chairman Emeritus of Kanaly Trust and also a member of our Investment Team.
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Now let’s get to the main event, and let me turn things over to Don Calcagni, the Chief Investment Officer of Mercer Advisors. Take it away, Don.
Don Calcagni: Hello everybody, and thank you so much for joining us today. I appreciate all of you taking the time to listen in and certainly to submit your questions. I do encourage you to submit questions. That’s, I think, one of the key hallmarks of this program and like Doug said, that’s one of the most popular features of our quarterly calls.
Just to set some context for what we’re going to review today, we’re going to really discuss the financial market returns and what’s happened. Certainly, we have seen volatility return so far this quarter. We did see some volatility in the market obviously earlier in the year, and then it sort of muted out. But we’re also going to go through returns. We’re going to talk a little bit about the economy; we’re going to talk a little bit about earnings, corporate earnings, market valuations. Then we’re going to finish today’s call discussing the federal debt, the deficits. We’re going to talk a little bit about interest rates, and then we are going to touch on the coming mid-term elections, which are certainly always an interesting topic, and I’m sure we’ll get a few questions on that as well. Let’s take it away and jump in.
The first thing that I wanted to touch on is that I often hear that October is a notoriously poor month for stock market returns. I was just speaking with our Chief Compliance Officer. He was actually at a conference, and a corporate executive from a major Wall Street firm basically echoed that same myth, that October is notoriously bad for stocks. I think when we look at the evidence what we find is that October is actually quite average. It is not notoriously bad for stocks, and you can see this looking at your screen. We just sorted the average monthly return for the S&P 500 Index for the last 90 years. When we do that, and we just look at the data, interestingly September is actually by far the worst month for stocks.
This isn’t to say that so far this October has not been poor, indeed it has, but what’s important to keep in mind is that on average there is nothing special about the month of October that would necessarily indicate that it is a bad month for stocks.
We often see this with Wall Street – there are a number of myths that are often perpetuated by the financial media-industrial complex that often when held up to scrutiny, we find out are just not true. I just wanted to begin today’s discussion by highlighting that data point that there’s nothing obviously about October that is unique. Drew, why don’t you take it away and walk us through what’s happened year-to-date in the U.S. markets, the Bond markets, but also the Oil markets, and we’ll go from there.
Drew Kanaly: Thank you, Don. The chart we’re looking at now is entry year volatility going back to 1980. The scale represents the movement in the market during the year, the red dots being the negative moves off of the beginning of the year, and the gray bars, the actual market close or the return over time. What we want you all to appreciate here is the volatility on average. Intra-year drops average about 13.8% over time. So what we’re seeing this year, even though the actual nominal movements have been quite alarming especially here lately, the actual returns as a percentage are well within line of experience, and far less volatile than the average experience over this time series.
I’m not here to tell you don’t pay attention, don’t ignore volatility – but what I am saying is the volatility as measured by history is well within reason. The only thing I’ll point to here when we get to returns is this year-to-date number on the S&P to give you something that reflects your mind’s eye about volatility. You can more than cut that return number in half due to market events here in October.
Don Calcagni: So, correct. These numbers are through the end of September. I do think that’s an important point for our audience to keep in mind and like Drew said, we’ve given up about five percentage points of this nine percent return so far in the month of October.
Drew Kanaly: Or depending on what time of day you ask. So going to Global Equity Returns on a year-to-date basis, I want everyone to focus on what the total allocation is to global equities. If we take all the stocks in the world and we weight them by the capitalization, the size of the company, the distribution of stocks that we can own in public markets works out to be about 55% U.S., 11% emerging markets, Europe (ex the UK) about 14%, but call the European stock experience closer to 20 – and then Japan, Pacific, and Canada. So that kind of gives you a feeling of what’s going on globally. Again, through the end of September we had nice positive returns for U.S. stocks, but that number of course has been cut in half, here in late October now.
On a global basis when we look at the EFAE which is Europe, Asia and the Far East, that number has moved decidedly negative in U.S. dollars. I don’t know off the top of my head how that works in local currencies through October, but put that number at negative five percent. That should fit more closely with your mind’s eye about your portfolio experience, if you are a day-to-day watcher of your portfolio.
This is kind of where the trouble lies. We’re going to get into all of what we’re focusing on that’s causing trouble for the market. If we look at this 10-year bond we’re looking at a year-to-date negative return of 3.73 through September 30. That 10-year yield is up to about 311, today, 312. So that year-to-date number is probably closer to something like four percent plus. There is an interesting analogy about interest rates Warren Buffet uses about valuing stocks. He says, “The market is like a weighing machine.” One of the thing it uses to weigh the present value of stocks or what PE multiple you were to assign is what your risk-free rate is. What we’ve seen is a rise in interest rates on a year-to-date basis, and you would assign a lot of the market volatility to the markets trying to weigh that, trying to assess what’s going up faster, interest rates or earnings. This explains much of today’s market behavior right here in interest rates. What you should focus on as a client of Mercer is the durations in your portfolio are much shorter. Your exposure to this type of interest rate volatility in your fixed income is much less. It’s a fraction of what the 10-year is experiencing, and this is intentional. We have intentionally altered our durations.
Something Don pointed out to me just before the call, if you go down to that US aggregate number showing a negative 2.4% year-to-date but a price return of negative almost six, there is a phenomena that has happened as U.S. CFOs have rightly extended their average maturity of their borrowings in the marketplace due to lower interest rates. It has caused this aggregate index to have a longer duration than you might experience historically. So the volatility of pure indexing investing is going to go up if we continue to experience a rise in interest rates.
So this one is near and dear to folks from Texas, especially Houston. This is oil markets, and what I would call to your attention here is the growth since 2015 of U.S. production, and right below that, the growth in consumption over that same period of time. It is any wonder that if global production roughly matches global growth you reach a price equilibrium – and we have done just that through the phenomena of technology. When you consider, much to the dismay of local service companies, a collapse in the average inventory of drilling rigs, yet a surge in production of oil. Thank you fracking and technology. We are incredibly productive in the oil patch, matching global production, and moving up U.S. production 24% since 2015. I’m unaware of such a prediction in the marketplace prior to that. Where we are today is about $66 on crude. Good news. Not necessarily good news for local folks, but good news for the consumer and good news for the economy. This is in a world where we have a number of headline risks which we’re all aware of out of Saudi Arabia. It appears that production and consumption appear to be in balance.
Don Calcagni: Thank you, Drew. I appreciate that. Some of those themes that Drew touched on we will touch on again as I review the economy and we take a look at market valuations. One of the things that I think is important to keep in mind is that the economy, the global economy but especially the U.S. economy, continues to grow – and it continues to grow at an above-average rate. On Friday, two days from now, we are going to get estimated GPD growth numbers. Most economists are projecting an economic growth rate north of four percent and certainly that, general speaking, bodes well for business, for stocks. It bodes well for your business. It certainly bodes well for stocks.
So the economy is doing well, it is expanding at an above-average rate. One of the reasons it’s expanding is that consumer spending, which makes up more than two-thirds of the economy, is exceptionally robust. Consumer sentiment is exceptionally high. The health of the average consumer, I should say “financial health” of the average consumer, is very good. What we have seen post-financial crisis is that most American households on average – and again I’m speaking in terms of broad averages – have paid down their debts. They are not carrying nearly as much consumer debt as they were just prior to the financial crisis.
So consumers are doing well and as a result, the economy is doing well. That’s also creating some stress on interest rates as the economy continues to grow. We have unemployment at one of the lowest rates in fifty years, right about 3.7% unemployment, and that’s one of the reasons the U.S. Federal Reserve continues to raise interest rates. I’m not going to get into the politics. I know the President has been exceptionally critical of the Federal Reserve Chairman, Jerome Powell, but the reality is the economy is doing very well, and the Fed is trying to make sure that we keep inflation in check.
So, moving on to corporate earnings… It should come as no surprise that when the economy does well, corporations do well. All of us are going on Amazon Prime and buying goods. The holidays are coming and just speaking for myself, my shopping habits have changed immensely. I never go to a U.S. shopping mall anymore. I do all of my Christmas shopping on Amazon, on Amazon Prime. So it should come as no surprise that corporate earnings are doing very well. For 2018, corporate earnings have grown about 20% in 2018 alone. Now a significant percentage of that, probably about half of that, is due to tax cuts that were implemented earlier this year. For next year, for 2019, corporate earnings growth is projected to fall from currently 20% growth down to 10% growth. So we will still see, we are still projecting about 10% corporate earnings growth for 2019, but it will be significantly less than it is today, and that’s an important point. It will be less than it is today. By the way, those are Wall Street estimates. Estimates are notoriously volatile and often incorrect. So as tariffs become fully implemented, as interest rates continue to rise I would just prepare our audience and prepare our investment team for the very real prospect that whatever we predict for next year will likely change. I think that’s an important point.
For the time being earnings are good, earnings growth continues to be healthy and positive, and the profit margin of S&P 500 companies, these are the largest 500 American companies by capitalization, continues to increase. Their profit margins continue to expand. These are all very, very good data points that really reflect a growing economy. Before I leave this particular slide I wanted to highlight this upper right-hand corner. Open any American newspaper or go to any news website today and you will see stories on the trade war between the United State and China, but also the United States and to a much lesser degree the European Union, as well as other countries. About 44% of sales of S&P 500 companies are sales of goods and services outside the United States. There is a very real prospect that as tariffs stay in place longer or become more widespread, that this will put downward pressure on stocks. That’s because it will be relatively harder for companies like Caterpillar – Caterpillar yesterday saw a very significant decline in its stock price. Caterpillar does significant business in China and is now dealing with the very real prospect of tariffs on their business in China. So, very important to keep all of that in mind.
At least prior to October, and like Drew said, even now despite giving up about five percentage points of market gains, the S&P is still positive currently, about four percent on a year-to-date basis. What’s important to keep in mind is that at least through the end of September, the market wasn’t even remotely close to being over-valued. I often get the question: You know, Don, the stock market has done so well. As least several weeks ago it was posting new highs and people begin to worry about the “valuation of stocks.” Are they “over-valued”?
I think when we just look at the evidence yet again, if we look at this perforated greenish line in the middle of our chart here – that’s the long-term 25-year average price to earnings ratio. You’ll see here that the S&P 500 is maybe, maybe trading at a very, very slight premium to its long-term average. I often hear the talking heads on television try to make the case that stocks are over-valued, and I will caution that on average it’s really hard to make that case, on average. I would keep that in mind.
When we look globally we see the same phenomenon. If we look at this chart on the right-hand side, we’re looking at that same data point, price to earnings. The gray bar just reflects the historical range of that particular ratio. The higher your blue diamond on that gray bar, the more “over-valued” your stock market is relative to history. The green bar in the middle of that gray bar is the long-term average. As you can see here, we’re maybe trading at a very, very slight premium to our very long-term average. When we look outside the United States and we look into the developed market – that’s what this DM stands for. That would be Japan, Canada, Australia and places like that. What we see there is no, we’re actually trading at a slight discount to our long-term averages. We see that in Europe. We see that in Japan, and we also see that in the emerging markets, so places like Southeast Asia, and South Asia, and Latin America. When we look globally, it is very hard to make the case that on average – and I keep coming back to that – on average, that stocks are over-priced.
Doug Fabian: Don, can I interject here and remind the audience that we will be getting into our Q&A session in just a few minutes. We have some excellent questions in the queue, so I wanted to invite anyone who has a question about today’s presentation, about the markets – obviously we can’t speak directly to your portfolio, but we can talk in general terms about Mercer Advisors’ investment philosophy. Please use the question tool on your tool panel to just send me your questions and we’ll be more than glad to answer those questions. We’re going to be getting to that in just a few minutes. Back to you, Don.
Don Calcagni: Thank you, Doug. So what I wanted to highlight – all of you have just heard me say several times that stocks on average don’t look like they are over-valued, especially now with our sell-off that we have experienced in October. But what I would highlight (and there is a typo in this screen and I do apologize to our audience), but if we look at the market and we broke it into two buckets, those stocks that are what we call value stocks, stocks with below-average “valuations.” These are the cheaper, less expensive stocks in the market, and that would be Bucket A. Bucket B would be the go-go stocks. Think of the internet stocks of the late 1990s, stocks that are very expensive trading at a premium to the rest of the market.
If we break them into two buckets… Here is the Russell 1000 Value which is currently trading at about 14 times earnings. Remember a moment ago I just showed you that the entire market, the S&P, was trading at about 16.8 times earnings. But then if we look at the Russell 1000 Growth Index (and this is the typo, this should say growth), the R1000 Growth Index, is actually trading at 22 times earnings. Remember 16.8 is the average, so these stocks here that are trading at 22 times earnings are very, very expensive. I’m not going to walk you through the modeling here that we do; this is for folks like me at Mercer Advisors. But what I will draw your attention to is on the left-hand side here. Here are the forward-looking expected returns that those two types of stocks are offering investors today. Many times when you work with your financial advisor at Mercer you’ll hear them speak to this concept called Expected Returns. Those are the forward-looking, longer-term return expectations for either your portfolio or a given asset class.
What you’ll see here is that if we actually look at the value stocks, they have a much higher forward-looking return expectation than the more expensive stocks in the marketplace. When we go out and look over longer-term periods of time, what we see is that growth stocks are actually trading at such a premium that today’s investors are probably – again, based on all of our data – probably offering investors a negative return over the next five years.
So Don, give us some examples. Well, if we look at a stock like a Netflix, which is trading at 100 times earnings; Amazon, which as I explained a few moments ago, I love dearly. I need Amazon in my life and it has transformed my Christmas shopping experience, but Amazon is trading at nosebleed levels. Great company, certainly growing profits – but that doesn’t change the fact that those stocks trade at very, very high valuations. When you look at stocks that are trading at 22 times earnings, what I would encourage our audience to keep in mind are those dotcom stocks from the late 1990s.
There was a time when the market had overpriced Yahoo so much that the market was claiming that Yahoo was worth more than Exxon Mobil, which was somewhat ridiculous. And today, Yahoo is basically non-existent. That’s what I mean by on average. So on average the market looks okay, but when we break it into certain segments based on its price to earnings ratio, what we see is there are segments of the market that are trading at stock prices that just aren’t sustainable, or at the very minimum make it very, very hard for those types of stocks to deliver positive returns on a go-forward basis.
So like I said a few moments ago, outside the United States, non U.S. stocks are actually trading at a substantial discount relative to U.S. stocks. I would encourage us to keep that in mind. I often get the question from our clients: Don, why do we own non-U.S. stocks? They haven’t done nearly as well as U.S. stocks over the last 10 or 15 years. And that is certainly a true statement, but we continue to own those non-U.S. stocks – one, because they offer the prospect of handsome, positive returns on a go-forward basis, just based on the fact that they are pretty inexpensive to own relative to U.S. stocks.
The other point that I would keep in mind is U.S. stocks are not perfectly correlated to U.S. stocks. We saw this on October 10th when the U.S. Stock Market had its second largest point loss in history. The Dow Jones fell 832 points on October 10th – that was a very significant decline, but non-U.S. stocks only fell barely a half of a percentage point. So U.S. stocks had fallen about 3.3% on October 10th but non-U.S. stocks had only fallen about .49% on October 10th. That’s what I mean by they are not perfectly correlated. They don’t always move in the same direction with the same amount of force. So that’s why we continue to own non-U.S. stocks.
In terms of U.S. stocks year-to-date, certainly they have not been good. Non-U.S. stocks are under-performing U.S. stocks this year, but it is important to understand why. I want to draw your attention to the right-hand side of this particular chart. When we look at Japan, or Europe, or the entire world or the emerging markets, what we have seen – you can actually take that return and break it into a couple of groups and basically assign it to a certain attribute. You know, why are emerging market stocks negative 7.4% year-to-date?
If we look at the colors of this particular bar chart you’ll see there is a blue chunk here. That’s what we call a currency effect. U.S. interest rates have gone up so far year-to-date, and what that means is the value of the U.S. dollar effectively is going up relative to the currencies in these other countries. For those of you who travel extensively to the emerging markets, one of the things that you should have observed so far this year is that relative to the prices that you paid last year in those places for goods and services, they should be relatively cheaper today than they were last year. So part of the negative return that we observe in non-U.S. stocks right now is because our currency keeps going up in value. So that’s an important point.
The biggest chunk here you’ll see is from what we call Multiples. One of the things that Drew said earlier was that the risk-free rate, meaning interest rates on say, short-term U.S. Bonds, keep going up. That’s what the Federal Reserve is doing – they are raising interest rates.
When that happens, all stocks in the entire world have to effectively be repriced to take into account the fact that they are now competing with bonds for your dollars, for the dollars that Mercer manages on your behalf. So what happens is those stock prices have to come down a little bit to adjust for the fact that you can now go purchase U.S. 10-year Treasuries yielding 3.12%, and so that’s what this green segment is reflecting, and that’s what we mean by Multiples.
If we look at all of them, all of them have this positive gray component, which is coming from earnings growth. I told you earlier that the U.S. economy, as well as the global economy, continues to grow. That’s reflected in that gray bar that we see here. So like I said, the economy is doing well but interest rates are rising, and that puts upward pressure on the U.S. dollar, but it also puts downward pressure on stock prices, as those prices take into account those rising interest rates.
So we’re moving into the end of our presentation here, and I look forward to opening it up to Q&A. I did just want to highlight one thing on this particular slide. We are continuing to accrue very large deficits in the United States. This year the Congressional Budget Office is projecting that we’re going to need to borrow $800 billion to plug the hole in our federal government spending. That means the U.S. government has to go into the market and borrow those dollars. That borrowing by itself will continue to put upward pressure on interest rates. I would also highlight this thin little purple bar that says net interest, $316 billion. As interest rates rise, that purple segment of that bar, that percentage of the federal budget is going to expand, because the federal government has about $20 trillion in debt that we are currently shouldering from previous years of spending where we had to borrow. So a larger and larger percentage of the U.S. federal budget will ultimately have to go towards paying interest on dollars that we borrowed last year, five years ago, 10 years ago, even 20 and 30 years ago. That’s an important point to keep in mind.
As short-term interest rates have been rising, this is what we call the “term structure” of interest rates. It’s a very fancy term that’s really just showing us that over here along the bottom, this is the maturity of certain U.S. Treasury Bonds, and the up-and-down is showing us the interest rate for those particular bonds. What you’ll see is this green line is much flatter than the gray dotted line. That is what has happened. The Federal U.S. Reserve Bank controls has influence over shorter-term interest rates. And that’s what has happened – they have been raising interest rates since December of 2015 to combat inflation. That’s what they’ve been doing.
That curve has now flattened. It’s not quite flat exactly because you can see that here. A 30-year bond is paying 3.19%. Many market commentators believe that this is a predictor of a coming recession. I’m not sure that I agree with that argument, but if you’re a market watcher, if you are watching CNBC you are going to hear them talk about this, and I just wanted to acknowledge that yes, this is happening in the bond markets and it’s something that we are paying attention to.
Like Drew said a few moments ago when he was talking about the bond market, the bond market has actually become riskier over time, and this is important. So when you’re discussing your portfolio with your advisor, one of the things your advisors will be highlighting to you is the average maturity. Sometimes they use the word duration which is related to maturity. The average maturity of a Mercer bond strategy is typically between two and five years, and that’s because we don’t want to lend out your savings for very long periods of time, especially when short-term interest rates are almost identical to longer-term interest rates. There’s very little extra return you get by investing in longer-term bonds.
What we see here is this gray line that shows the average maturity. Over here is the duration. Like I said, that’s related to maturity. What we have seen is that bonds in the marketplace are now being issued for longer and longer periods of time, which is actually a smart thing to do for a corporation. Think about you when you are buying a home. If interest rates are really low you would want to lock that in for maybe a 30-year mortgage rather than a 10-year or a 15-year mortgage. Corporations are doing the same exact thing.
So what does this all mean for politics? Here we are on the eve of a very significant mid-term election. The country, I think by any objective measure we would agree, is sharply divided politically, and oftentimes when I get pulled into these discussions, members of each party would like nothing more than for me to come on stage and say that yes, one party has all the answers and the other one does not. What I would argue is that’s not true. There’s really no evidence that one party has all the answers, or that one party is better than the other.
What I wanted to draw your attention to, if you look at this top chart here, all we’re showing here is periods of time, we’re showing the average return on the stock market during periods of Republican control of government. That means they controlled Congress and they controlled the White House. So when Congress was controlled by Republicans and when the White House was also controlled by Republicans, we saw an average stock market return of about 6.3%. But it’s important to note that has only existed about 11% of the time. Meaning 89% of the time the Republicans did not control the entire government. The same can be said for Democrats. Democrats controlled the entire government about 28% of the time, but they did have a lower average stock market return under those particular terms when they controlled them, when we had single-party control.
Most of the time we have divided government. You’ll see about 61% of the time either one party controls Congress, another one controls the White House, and it’s actually under those periods of time, under those situations, those scenarios, where market returns are actually the lowest, about 3.9%.
Now to be fair, some have argued that this is why the market is pretty shaky right now. This is why we’ve seen an uptick in volatility. Most political pundits I think would agree, or they are projecting, that the Democrats are going to win the House of Representatives. I don’t know. I’m not a political scientist. I think what they’re hinting at is when we have divided government it’s generally harder to pass a budget. It’s generally harder to agree on regulatory frameworks. It’s just generally harder to pass legislation at all. But what I would highlight here is that this is a very simplistic analysis that assumes that market returns are directly related to which political party is in control of Congress. I disagree with that. I think there’s a lot of things that impact the market. There are a lot of things that impact economic growth.
I get a little nervous when I look at this particular charts that are trying to make a case that one party is maybe “better for the stock market,” and maybe one is “better for the economy,” which is really what this bottom chart is trying to show us – that while Republicans have in theory been better for the stock market when they controlled the entire government, that the opposite is true when we look at the economy. The Democrats, when they had single-party control of government, the economic growth was higher than when the Republicans controlled the entirety of the federal government. Again, I know partisans from both sides like to highlight – they tend to cherry-pick this data to try to argue for their policies relative to their competitors. I think it’s important to keep in mind that there are a lot of things that influence markets, and there are certainly a lot of things that influence the economy.
So let me stop there. Drew, Doug, do either of you want to add to this? I know this has been a hot button topic. We get a lot of questions on this, and I certainly want to make sure it’s certainly not just my view that’s reflected here.
Doug Fabian: Don, I wanted to make the comment to people that their money really doesn’t care who’s in control of government. We have had long-term rates returned in the United States for decades, for centuries, and we continue to innovate. As long as that innovation continues to happen in the marketplace organically, we’re going to continue to see stocks be the superior returning investment vehicle. There is always going to be volatility, there is always going to be bear markets, but over the long-term stocks continue to do well, and it really doesn’t matter which party is in control of Congress. Drew?
Drew Kanaly: Yes. The only thing I would say is markets are discounting mechanisms, and they can discount good news and they can discount bad news, but they have a very difficult time of sorting through news they can’t predict, the unpredictable. So the fact that this particular election cycle is close gives folks betting on the market – and there’s a certain element here that does that – they don’t know. They simply don’t know how to discount the information. It’s too close to call. So that segment of investors, they have a very difficult time discounting or pricing what they are going to do. So you see this time and time again when you have vague data on any one given point, whether it’s political or earnings going forward. The market has trouble discounting it.
Don Calcagni: One would certainly agree. Doug, now is probably a good time to open this up to questions. I would imagine our audience has a lot of questions, and why don’t we dive in?
Doug Fabian: Ladies and Gentlemen, I’m going to coach my colleagues to be a little brief because we do have many questions in the queue, and we want to answer as many questions as we can. I do want to mention, ladies and gentlemen, that we will formally close the webinar at the top of the hour, but Don, Drew and I can stay on the line and answer some additional questions after we go over the hour. We do want to be respectful of everybody’s time, and we do have a couple of closing comments.
Let’s jump right into the questions and Don, this question came in via email: In February of this year, Mercer Advisors adjusted our portfolio’s equity exposure. Has Mercer used the recent correction as a buying opportunity? Don?
Don Calcagni: That’s a great question. Just to clarify a little bit, we rebalanced our portfolios in late January, and part of that exercise, when markets are doing very well requires you to sell part of the stocks in the portfolio and then go and purchase bonds in the portfolio. That just gives you a very broad overview. That was a rebalancing exercise. We were not responding to any prediction that we had on what was going to happen in early February. Certainly our timing was excellent and certainly we’ll take the gains that come out of that, but that was a rebalancing exercise. We were not dialing down our exposure to equities in response to “something going on” in the markets. The same is true now. We are not rebalancing to “go look for buying opportunities.” We are, right now, and I was just meeting with the Investment Operations Team right before the call, and they are going through their testing. We are going to be rebalancing our tax-sheltered portfolios in early November. We are preparing to do that, and certainly the market sell-off is part of the calculation that goes into that. But like I said a few minutes ago, the markets are still mildly positive for the year, so I’m not entirely sure we’re going to see a significant tactical shift, if you were, in any of our client portfolios as a result of the October sell-off.
Doug Fabian: Don, this question comes from one of our clients who’s asking about the PE ratio. What does the PE average look like if you were to take out the FAANG stocks? Does it come down that much?
Don Calcagni: To be honest, I don’t have that data at my fingertips, but I think we can intuit that yes, it would come down significantly. The reason I say that is because if you think of what’s in the FAANG stocks, you’ve got Facebook, Apple, Amazon. Those are three of the largest stocks by capitalization, and all three of them are trading at above market PE ratios. It should come down, but I can’t tell you off the top of my head by how much, but it should come down quite significantly because the S&P is cap-weighted. It gives more credit to those stocks than many other stocks just by virtue of their sheer size. So it would come down – by how much I can only guess off the top of my head, but I don’t see any reason why it wouldn’t come down fairly significantly. That’s a good question.
Doug Fabian: A question here from a client: What is your sense about the impact on the market short-term and long-term because of the recent tax cuts and corresponding growth of the federal deficit? A lot going on here, Don.
Don Calcagni: Short-term tax cuts tend to be a bit of a sugar high, and many economists have referred to the current tax cuts as being exactly that. I would generally agree with that. Consumers have more money in their pocket, they’re going to spend it. Americans, on average, don’t do a very good job saving, so every extra marginal dollar they have, they tend to spend most of it. So I think short-term it tends to goose the markets, it tends to goose the economy a little bit. But longer-term, I think it’s a drag. It’s a drag because of the growing federal debt. Every dollar that our federal government has to allocate to paying interest on monies that they borrowed years ago is a dollar that they can’t spend on things like health care or defense spending, or anything else you would deem to be a valuable pursuit. I think longer-term it’s a drag because eventually the government is going to have to raise taxes to pay back or to meet its debt obligations. If it doesn’t raise taxes to pay its debt obligations we could be faced with another debt downgrade. We saw that in 2011 where the U.S. government’s federal credit rating was compromised by S&P, but that was more political than financial. But there could come a day where if we’re struggling to make our interest payments, in theory that could really hurt our ability to borrow going forward.
Doug Fabian: A question from one of our clients: In light of the varying gyration of international events, tariffs, oil production, why are we continuing to have an allocation to the international markets?
Don Calcagni: It’s important to understand there is a difference between uncertainty and risk. When you look at geo-political events, what’s happening in Syria or Saudi Arabia, and places like that, that’s what we call uncertainty. It’s very hard to predict how those events could impact capital markets. I think that would be my first comment. My second comment would be, I would be very careful to throw all 200-and-some countries outside of the United States into the same bucket. Right? What’s happening in Syria or Saudi Arabia doesn’t mean that you should not own Canadian or Japanese stocks. I think it’s important to keep that in mind. If we go back to periods of time when non-U.S. stocks did exceptionally well – think of the 1990s, non-U.S. stocks did very well in the 1990s. Look at what happened in the 1990s: We had the collapse of the Eastern Block, we had the collapse of the Soviet Union. We had war in Eastern Europe. Remember the Bosnian War? We had the war in the Middle East. We had the first Persian Gulf War in 1991. So in the 1990s there was no lack of extreme geo-political events. We had loose nukes. That was the big fear in the ’90s, and yet we had phenomenal returns in non-U.S. stocks. So I would be very careful tethering geo-political events that we read about in the newspapers to what we think non-U.S. stocks are going to do going forward.
Drew Kanaly: Don, the only thing I would add to it is you have a bit of a reckoning happening in the European Union, correct? You have Brexit being sorted out, and then this very interesting battle between Brussels and Italy over the Italian budget. So it really makes markets pause again, right, because they are having difficulty discounting what this reckoning, what the outcome is going to be in the terms of the Brexit final outcome. You just don’t know. How do you discount that in terms of how Brussels and Italy solves this Italian budget problem – how do you discount that? You just don’t know. Given valuations, you could be reasonably certain that you’re certainly not buying European stocks at peak valuation, but you are in a period of uncertainty so it’s difficult for them to discount that.
Doug Fabian: Question here from a client: If Democrats take over the House in the mid-term elections will the stock market slide lower?
Don Calcagni: I think that’s exceptionally hard to predict. Many market pundits would argue yes on the premise that if they take over the House, that they could launch a number of investigations that could really bring the operation of government to a standstill. I do think there is some concern with that, but I think it’s so hard to say. If the implication of the question behind the question is: Do Democratic party policies tend to be anti-growth or anti-stock market? Maybe, I don’t know. Certainly in the 1990s when we had a Democratic president the market did exceptionally well. I’m not sure. If that’s the question behind the question, I’m not sure I would arrive at that conclusion. What I would say is any time – and the evidence shows this – any time we have divided government that it’s harder to govern because you have two different sides with very different views on regulation and taxes, and things of that nature. So I don’t know that I would agree that the market will “slide” by virtue of the fact that the Democrats would win the House of Representatives.
Doug Fabian: This is a very specific question from a client that has both a financial planning and investment implication. I just retired, I’m 65 years old and have a net worth of over $3 million. A million of that is in real estate and the rest is invested in a 60/40 Mercer Portfolio, 60% bonds, 40% equities. What are your thoughts on how I will fare in the next 20 years?
Don Calcagni: The first thing I would say is that this is why every Mercer client has a customized financial plan. When you look at any financial plan, two of the most critical determinants of success would be one, our spending decisions, our cash flow that we are withdrawing from our assets. When I think of somebody who has about $2 million in liquid assets and $1.3 million that are non-liquid, illiquid, a $2 million portfolio could easily sustain about $50,000 a year in withdrawals, maybe $60,000. That’s only about a 3% withdrawal rate, which brings me to my second point. We’re on a rising interest rate environment. As interest rates rise, relatively speaking it’s going to be easier for retirees to generate income from their retirement assets. As rates rise, if we get back to a place where we have a normalized interest rate environment, which I think we’re going to get there, that portfolio could probably sustain $80,000 to $90,000 a year relatively comfortably in withdrawals. Again, I’m ignoring Social Security or pensions, or anything else that this particular client may have coming in. I think the client would fare well if they stick to a well-designed financial plan that has clearly mapped out a sustainable cash flow withdrawal from those assets. If the client were to withdraw $150,000 to $200,000 a year from that portfolio, I don’t care what his market returns or her market returns are, they are probably going to run out of funds at some point in retirement. So that’s how I would approach that particular question.
Doug Fabian: Great, Don.
We are, ladies and gentlemen, at the top of the hour. We want to be respectful of everybody’s time. We have a few closing comments that we would like to make and I want everybody to know that this webinar is going to be posted at MercerAdvisors.com in the next day or so and you’ll be able to review that webinar, as well.
I’ve had a couple of questions about the slide presentation, and I would encourage all of the clients on the call to contact their advisor to discuss the slide deck. Then also, I wanted to talk for a moment about the Science of Economic Freedom. This is our education initiative, and if you have listened to the Science of Economic Freedom podcast you probably recognize my voice. I am the podcast host. One of the things that we do in the Science of Economic Freedom is we really are looking at what’s happening in the investment markets. We’re looking at what’s going on from a personal finance perspective, and we’re recording a weekly podcast to help clients and the families of clients – and also people who are not even clients – be able to make progress on their journey to economic freedom.
I wanted to mention a couple of podcasts specifically because it ties right into market volatility. You can reach the Science of Economic Freedom podcasts by going to the ScienceofEconomicFreedom.com. “How to Navigate a Stock Market Correction” was a recent podcast we did. I interviewed Don Calcagni on “Good Things Can Happen in Bad Markets.” We did a recent podcast on “Estate Planning Best Practices,” and last week’s podcast was on “How to Fund a College Education Without Going Broke.”
These are all tools and resources that are available to all clients, all friends of Mercer Advisors, and we would encourage you to go out to the ScienceofEconomicFreedom.com and listen to those podcasts, and get more information about how you should be thinking about personal finance and market issues going forward.
I wanted to ask Don and Drew if they had any final comments about today’s webinar before we finally wrap things up. Let me start with you, Don.
Don Calcagni: I would just encourage our clients to keep in mind that market corrections are a normal part of capital markets, and I would definitely encourage all of our clients to sit with their advisor, revisit their financial plan. If you understand why you’re investing and what your goals are, what happens on a day-to-day or even month-to-month basis in the market should actually be immaterial to what you are trying to accomplish. I’ve seen more wealth lost due to a lack of planning than to any market correction or bear market. So I would encourage our clients to focus on the financial plan, work with their advisor, make sure they’re in the best portfolio that works for them and their financial plan.
Doug Fabian: Drew?
Drew Kanaly: Yes. The only thing I would add to that is in the planning process I think it’s always good and instructive for clients, at least in my practice, when I show a projection for retirement we don’t get into linear projections. We stick with Monte Carlo simulations that more closely represent what the experience going forward is most likely to be like. And then we’ll sprinkle in some events. We’ll intentionally show the client what a significant market decline, what the experience might look like, in the first couple of years of retirement. I think that’s instructive for people to see the sensitivity of their retirement plan to an unforeseen force majeure. I’d encourage you, especially recent retirees, to make sure they speak with their advisor, and test the portfolio’s sensitivity to such events.
Doug Fabian: Thank you, Drew.
Ladies and gentlemen, next week we will be releasing our Quarterly Wealth Point Newsletter, and we will be featuring year-end tax planning in this particular issue, so watch your email inbox for the current copy of Wealth Point. If you did not have your question answered today, or if you would like to clarify any of the topics that we discussed, we want to encourage you to contact your specific investment advisor.
Thank you for attending today’s Quarterly Conference Call. We will be sending a recording of this event to all clients. Please give us any feedback in the survey we will be sending out, and speak with your advisor if you have any questions.
This is Doug Fabian. Thank you very much for being a client of Mercer Advisors and for joining us today.
This document is a transcription. While it is believed to be current and accurate, it is not warranted to be so. Divergence from the original in format and pagination are to be expected. To ensure accuracy, play the audio file and listen to the quote yourself to verify what was said.
While the webinar presenters answered specific questions from audience members, the answers should not be construed as personalized investment advice tailored to that individual’s specific financial circumstances. Answers were provided upon the information provided and were intended to be educational in nature.