It IS Different This Time. It’s Actually Not As Bad

Wealthy Behavior: It IS Different This Time. Its Actually Not As Bad
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00:00:10 – 00:05:02
Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial. The podcast that digs into topics strategies and behaviors that help busy successful people build and protect their personal wealth. I’m your host, Sammy Azzouz president of Heritage Financial, a Boston based wealth management firm working with business owners, executives and retirees for more than 25 years. Now, let’s talk about the wealthy behaviors that are key to a rich life.

Welcome to another investment bonus edition of the Wealthy Behavior podcast where I sit down with our Chief Investment Officer, Bob Weiss, to discuss what’s going on in the markets and the investment universe right now. Last month, Bob and I discussed how the market looked year to date given the high inflation that we were seeing, the feds aggressive rate hike policies, touching on a bear market, and the potential for a recession. And those are themes that still continue to dominate. Bob, I would imagine that you’ve basically been focused on many of the same things. Absolutely. The macro stuff is definitely the question of the day. Where are stocks going? People are always asking, but now it’s are we going into a recession? How much farther down is there to go? Is it a buying opportunity? That’s what we’re hearing more focus on. Yeah, and there’s a lot to that and one of the things that we’ve been sharing with clients in our review meetings is just a reminder that the markets are a leading indicator. And so that the sell-off that we’ve been seeing is signaling some kind of slowdown in the economy and corporate earning picture, whether it leads to a recession or not, is more of a technical measurement. But it is signaling something. And also, if investors are worried about the duration or how long this kind of weaker market can go, that whole aspect of the market being a leading indicator also means that the market will turn around, or should turn around, before the inflation picture materially improves, before the economy starts to recover, before earnings pick up, right? Yeah, I mean, that’s a great point. And that’s something we constantly have to tell clients that a lot of bad stuff that could happen is priced in. When you’re down, about 20% in stocks and you haven’t seen big cuts in corporate earnings, the economy has been still growing. It depends how you calculate GDP, I suppose, and take that one back a bit. But overall, things still look pretty good minus inflation. And stocks are down quite a bit. So there’s more bad news priced in than we’re seeing today. So we’ll eventually see that bad news hit, but that doesn’t mean the market at that point needs to take another leg downwards. That’s what the market’s been kind of anticipating right now. Right. Great. So what have you seen over the last little bit since our last podcast where we discussed this, any updates on your view of inflation or what the fed is doing? Yeah, I guess inflation is obviously the big question and what we believe is pretty clear is the fed is going to tackle inflation. They are going to what we’ve called “pop the inflation bubble”. It goes back to thinking what Volcker did in the early 80s and the fed needs to restore credibility. So in hearing Powell and what they’re talking about, we do think they’re going to go after inflation and do what it takes to get us out of this inflationary environment. So then the question with that is if you say they’re going to do that, then will we have that soft landing where they do it and they don’t really drag the economy into a deep recession, in which case we’ll have a buying opportunity. Or will things get pretty bad in the economy? Because they’re willing to do that at the expense of fighting inflation. So those are really the two things we’re looking at, the two paths and it’s almost like you could say maybe two thirds probability that it doesn’t get too bad and one third that they do have to hurt the economy in a big way. And we’re down 20%. So it’s almost like it’s two thirds priced in. So just stepping back is kind of a simple framework for how we’re looking at things today. Yeah, absolutely. And you’ve used the phrase kind of priced in a few times already in this short podcast so far. What do you mean by that? So investors invest based on the future, not today. Tech stocks are a good example, an extreme example where people will buy unprofitable tech companies, not for the cash flow they’re going to get tomorrow. There is no cash flow tomorrow. They’re looking out 5, ten years even. So investors make decisions, not based on what’s happening today, but what’s going to happen in the future, so I just gave a single stock example. But you step back and will the market is stocks in aggregate.

00:05:02 – 00:10:05
So it’s investors thinking what’s going to happen over the next few months, over the next year or two. And that informs the price they want to pay for assets today. So that’s what I mean by priced in. So one recent example, we’ve chatted about is the fed signaled a lot of rate hikes coming up and well, earlier this year, there was a lot of signaling on future rate hikes, the market had expected aggressive rate hikes and once that news is out there, it’s basically or should be reflected in market prices. Exactly. That’s why short term rates like the two year treasury rates around 3% right now. And the fed funds rate isn’t there yet, but that’s the market basically saying over the next two years, it’s going to get right around there. And that’s the, I don’t know if this is the right phrase, but that’s the rational response. But we all know that markets don’t just price in news. They can overshoot in either direction, right? And so that’s why it’s so hard to know kind of mathematically where these things should start and stop and not end and fear and greed does take over and push things further in a direction once we’ve started. We were chatting a little bit about one measurement of fear in the marketplace, which is the vix. And it was kind of connected to this idea that the market seems a little range bound right now. We’ve kind of been floating between, I don’t know, 18% to 24% down, the bond market struggled to start the year, but it’s been much more even keeled lately, hasn’t recovered, but it stayed within a narrow stretch. And I kind of asked you, what is going on with the vix and what are you seeing in terms of that volatility index compared to other moments in time? Yeah, so the vix right now, it’s around 30 and this year peaked 38, 39 is as high as it gotten. By comparison in March of 2020, when we were in the COVID crash, it got up to around 70. And back in the global financial crisis in November of ‘08 that went to about 70. So at that level, 70, that’s the real panic level. And I think what you said a minute ago is interesting where markets are normally pretty rational. Investors take out excel spreadsheets, calculators, forecast, using reasonable assumptions and it all get’s, I’ll say it again, priced in. And you have buyers, sellers and the prices typically, right? During some periods where there’s panic, emotions take over. The calculators and spreadsheets go out the window and people are just trading, selling without thinking straight, and that’s when their opportunities. That’s when markets become inefficient, which isn’t too frequent. I would say in a big way especially the macro way. So at heritage we do look for things like that. When we think emotions are taking over rational market behavior and that’s when we think it’s time to step on the gas a little bit. And when people are panicking and there’s blood on the streets, that’s when you want to buy, that’s looking at a higher vix level than we are at right now. That can cut both ways. Anecdotally, I would share with you and we talk about it as a team a lot. Clients are fairly okay, I guess for, I don’t know if that’s a great way to explain it with nobody loves the market that we’re seeing right now, but there have definitely been other environments where I’ve seen a lot more nerves and concerns amongst investors. I mean, you referenced 2008 was the granddaddy of them all. Is that what you’re seeing kind of anecdotally by saying it could swing both ways. It could mean that, you know, the worst is yet to come because people haven’t fully thrown in the towel or it could mean that, you know what, people are all right, they understand we’re going through a process here as it relates to inflation and they’re basically just going to ride it out and we may not have a much steeper leg down. You said it right. Clients are pretty well informed these days. What’s happening in markets, I hate to say it isn’t that complicated, but I feel like it’s not that complicated. Like in COVID, it’s like are we going to depression? How’s all this going to play out? And there’s a lot of, we’ve never been in this before. The financial crisis may have major investment banks failing. What happens when Lehman fails? No one really had been through that before almost since the depression. But this time around, it starts on inflation side. If the Fed’s going to fight inflation, interest rates are going up, stocks are going down and there’s a war in Russia and Ukraine, to understand what’s going on. It’s not overly complicated. So I think people watch the news and see the headlines and get that there’s challenges in the world right now.

00:10:06 – 00:15:03
It hasn’t been a great 6 months to be invested. Yeah, and I think that’s a great point with the bear market that we saw in March of 2020 related to COVID. I think there was a lot of uncertainty about what is this thing, what is this pandemic? What are we going to go through? And then the market recovered really quickly. Extremely quickly. And I think for the next year, we were answering client questions, why would the market be recovering this fast when the world is still pretty much shut down? And it was a very kind of disorienting confusing environment. And I think like you said, major institutions going under in 2008, people wondering they should pull their cash out of the bank. This is more straightforward. It is easier to wrap your head around and hopefully that can lead to some investor optimism that we may not get that panic route based on the information that we have today. Yeah, I think we probably won’t see that 2008 type panic, March 2020 to panic. The market is working through some things- are at the bottom, we don’t know, but I don’t think we probably won’t see the vix at 70. And get into that environment again, which is a good thing. Other than a little bit of us on the investment team that love those opportunities when they come, but no one else likes it – Advisers and clients. So, you know, hopefully it doesn’t get too much worse. Absolutely. I agree Bob, and so kind of staying on stocks for a second. There really hasn’t been this year a major performance differential between U.S. and international stocks or developed international or emerging markets. This hasn’t been a year, I think, and correct me if I’m wrong, where you’re invested globally has made a huge difference in terms of your returns. Yeah, the one thing I’d say is give emerging markets a little bit of a plug. They’re down 15% year to date. U.S. market is down 20. So about 15, not good down 20, not good. But still at 5% outperformance from emerging markets and that’s a little unique because emerging markets have what you’d call a higher beta, like 1.1, 1.2. So base case, they should do 1.1 – 1.2 X what the U.S. would do because there’s more risk. So if they were down 25%, it wouldn’t be a surprise at all. So to see them down less in a risk off market it’s good. For an allocation of emerging markets this year. No, thanks for clarifying and what would you attribute that to bob since they are higher volatility, higher beta stocks, why are they holding up a little bit better? Yeah, two things I’d point to, one is valuations. We’ve been saying this emerging markets are cheap and the U.S. market has been expensive and expensive has been selling off, cheap has been holding up a little better. That’s the value/ growth story, whether you’re talking about companies within the U.S. or regions. And the second is emerging markets have more commodity producing countries. Like you think of Brazil, for example, a lot of oil and precious metals, those are more concentrated in emerging markets. So higher inflation has benefited companies in those countries in some cases. And is it true that China is easing their monetary policy or at least not tightening it like we are? That’s true, yes. So that, that’s helpful as well. And they’re a big part of the emerging markets. That’s more of a recent story, like the last month or so. China has been a tough place to invest. I don’t have the exact numbers on the Chinese market in front of me, but I’m pretty sure they’ve had a bad year. And that’s starting to turn around, but they still have a lot of catching up to do. Gotcha. All right, so that’s not one of the primary performance drivers. And then you touched on valuations, but as value investors, we continue to be smiling over the difference between value and growth year to date. Yeah. In front of me, I have the MSCI USA value index. It’s down 12%. The USA growth index is down 29%. Wow. So growth down 29% value down 12%, big value premium there. So earlier, I made the joke about calculators and spreadsheets. It’s true now when things get tough, people are saying, okay, what’s the fair price for a company? And when they have cash flow, it’s easier to come up with a price that’s close to the current price than to talk about companies that are based on dreams and hopes. And when you’re less optimistic, those can fall a lot more. Interesting, that’s similar, I guess, to the tech driven bear market in 2000-2001, or is it? where basically value held up much, much better than growth, and I think early on was actually positive.

0:15:03 – 00:20:02
I remember small cap value was making money while the NASDAQ was getting obliterated. Are there some common themes between this bear market and that one? Yeah, definitely similarities, some differences as well. Similarities, there are like I’ve said a couple of times the unprofitable companies that are trading at really large valuations. What’s different is there are also very big tech companies that are very profitable, like Microsoft, the two big names that are quite profitable trade at reasonable valuations a little high. Throw Google in there too. But we didn’t have that in the tech bulb. But it’s still around that. I’m not going to go through a handful of names because there are a lot of them. But you also have companies that are worth 10 billion, a 100 billion that aren’t making money. And a $100 billion company not making money now is what we saw in the tech bubble. Got it. Understood. So switching gears a little bit to bonds. You know, I mentioned that Bond volatility had leveled off a little bit. And you had in preparing for this to just shared with me that the ten year yield has remained kind of around the same level. I think you said it was around three. And what are you seeing in the bond market today? And what are you thinking of doing about it? Because I know we’re very active in the fixed income space historically. Yeah, if you step back a little bit and think about market cycles and how they work. As you get towards the end of a market cycle, what you see is the economy is hot, inflation starts to run high. Inflation runs high, the fed starts to fight inflation, raise rates, but while inflation is high and fed’s initially starting to raise rates, the bond market gets spooked. So yields have to adjust. Inflation is high, Fed is raising rates, uh oh bad environment for bonds and bonds sell off. And at that time you can also see stocks sell off. That’s what we have been going through and might say, been going through up until a month or two ago, where you’ve been seeing stocks down and bond yields up, also known as bond prices down. Now we might be transitioning to a second phase of that cycle, where the economy slows down, might go into recession, inflation isn’t as much of an issue anymore and bond yields fall. That’s when you have what people call the flight to quality. So bonds go from, oh, no, I don’t want to own them inflation is high too. Oh, I’m not going to lose money in bonds. Please let me lock in a two or 3% yield. So if things get worse earlier on when I painted out the scenario, the not soft landing scenario where we do head into a recession, we can definitely see more of a flight to quality, meaning investors buy bonds, yield on a ten year treasury goes from three back down to say two, even one and a half. That definitely something that’s in the cards. And if that happens, you’ll get a 10% return in bonds. And so the thought process there would be what? To add some yield? to add some interest rate risk? Because if we get a market sell off and a flight to quality we will make out as investors, but if we don’t, you’re getting a higher yield and the interest rate risk story doesn’t fully play out. Yeah, that’s a good bet basically. I guess. Yeah, maybe to frame it a little bit. We’ve been talking a lot about real assets for the last two years. And so it’s a nice structure and if inflation is high we will do well and we weren’t saying inflation is going to be 8%. That’s why we’re doing this. But it did come in high and that allocation to work really nicely. What’s the opposite of real assets? What’s the opposite of having something that will be there if inflation runs at 8%? Well, long-term government bonds are pretty much as good as it gets. And it’s not like we’re calling for that, but it’s a scenario that could play out. And with our clients we’re all about diversification, having our basis covered. And part of thinking is just shifting a little bit off the bet from that position that helps in the 8% inflationary scenario that the one that helps with inflation comes in below expectations. And the key thing and some people might be listening to this and say, are you guys crazy. It’s that markets price and things before they happen. So it’s not what’s happening now, but it’s what’s going to happen in the future. No one knows. So it’s definitely a possibility that inflation slows more than people are expecting. Got it. And when you said treasuries, the opposite of real assets, what did you mean by that? So inflation is high, if it increases above expectations, so all of a sudden you wake up while we’re in inflationary environment, and say I didn’t know that.

00:20:03 – 00:24:04
What happens, bond yield sell off, people say, I don’t want to own a bond when an inflation is at 8%. And things like real assets go up, the flip side of it is you wake up and say, inflation is nowhere to be found all of a sudden, a 3% yield in bonds is a 3% real yield. So you are getting 3% above inflation, but what you’re looking for in a financial plan in many cases to get 3% above inflation. So when there’s no inflation, bonds are attractive. And you don’t even need a 3% yield on a treasury you’ll get one or two and be happy with that. So that’s if that makes sense that’s what I meant by the opposite. Yeah, no, it definitely makes sense. And it’s great in terms of the thought process and I’m sure our listeners love kind of hearing an investment teams thoughts developing in action basically as a reaction to market movements. So thanks for sharing that with us. I want to wrap up with what I think, although I haven’t ranked them is my least favorite investment or the thing I think is the dumbest, which is crypto. And I know you’re not a fan of it, so you’re probably wondering why the heck I’m bringing it up. But it’s almost as a warning. You know, you talk about the idea of being a value investor. You talk about the idea of things sell off, they can become more attractive. And it’s a warning that just because something speculative like Bitcoin goes from, I don’t know where it was 60,000 to 19,000, it doesn’t mean it’s now a value because the underlying asset is still this speculative confusing mess. You wouldn’t become as an investor, bob, more attracted to something you weren’t attracted to just because it sold off by two thirds. No. I mean, Bitcoin’s market cap I just looked it up is I have trouble even saying this if I’m right counting these commas 364 billion. So $364 billion for all the Bitcoin in the world. I’d rather $364 billion if you ask me than all the Bitcoin in the world. Could that go to a 100 billion sure? Could it go to 3 billion? I don’t see why it should be over 300 billion. It used to be a trillion though. But I wouldn’t be jumping to buy it right now. And that’s funny because Warren Buffett had said he wouldn’t buy all the Bitcoin in the world I think for 25 bucks, I think that one might have been hyperbolic. I think I’d probably exchange $25 right now for 364 billion or whatever you said and then immediately turn around and get a huge tax bill, but his point, I think, was the point you and I were talking about is it’s not just price declines. There has to be some kind of value to the assets, some kind of underlying purpose to it. Exactly. Nice. All right. Anything else, bob on your mind is you look out at the horizon with your investment team? No, I think we covered a lot today so nothing else to add for now. Great. Well, thank you, bob, for your thoughts. And I hope you have a great long weekend. Thanks, you too Sammy.

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