Inflation, Markets, and the Magnificent 7

This transcript may contain spelling and grammatical errors.

[Sammy Azzouz]: Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial, the podcast that digs into the topics, strategies, and behaviors that help busy and successful people build and protect their personal wealth. I’m your host, Sammy Azzouz, the president and CEO of Heritage Financial, a Boston based wealth management firm working with high net worth families across the country for longer than twenty five years. Now let’s talk about the wealthy behaviors that are key to a rich life.

Our regular listeners know that I usually talk to our chief investment officer, Bob Weiss, at the beginning of each month to help break down what’s going on in the markets and investment universe. I asked Bob to join me a second time in April so we can discuss the latest batch of inflation and economic data and talk about an investment question that we’re getting a lot lately. So, Bob, earlier this month, we had a CPI report that came in hotter than expected. And for the second month in a row, inflation was higher than the prior month. So based on CPI, we’re up to three and a half percent now, and we were 3.1% in January. Stocks sold off on the news. Yields increased, which means bonds sold off as well. Then the PPI report the next day came in better than expected and so or as expected. And after a five percent pullback or so in stocks, we’ve seen stocks do better recently, yield stabilize. So this is just a very long way for me to ask, did anything change in your mind with the April reports?

[Bob Weisse]:Yes. I think it did. So markets had been, I think, buying into a narrative that, Fed funds rates are coming. There were up to over, I think, six to even up close to seven rate cuts priced in at one point earlier this year. So the narrative was that the inflation beast has been slayed an accommodative Fed is around the corner, rate cuts are coming, and you know, Goldilocks is the term for that. You know, inflation, that’s gonna be a thing of the past as far as above the Fed Funds target. And the market was pricing that in, and that’s why we had such a strong Q4 as it was getting priced in most of Q1. And then just to put more in, the Fed’s words, this was last week on the sixteenth, chairman Powell said, the recent data have clearly not given us greater confidence and instead indicate that it’s likely to take longer than expected to achieve that confidence. So it’s what Powell said referring to rate cuts. Right now, given the strength of the labor market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work and let the data and evolving outlook guide us. So hearing from the Fed themselves, they’re saying, okay, we’re seeing this and guys, rate cuts are not around the corner. So cool your jets on this. And what’s the this, Bob? Inflation. Inflation coming in coming in higher. So we had been on a nice downward trajectory. While inflation was elevated, it had been declining, you know, from nine to eight to seven to six to five, etcetera. And now it it’s going up. So, that what they’re concerned about. And it’s not I don’t wanna sound overly alarming, but it’s that narrative of, you know, the script that, okay. Rate cuts are around the corner. Everything’s gonna be great. And now it’s oh, actually, there’s a path where maybe inflation is a little stickier. And, right now, there’s it’s about a twenty percent chance of rate hikes happening this year. And I think the market’s pricing, like, the base case is one and a half cuts, which is next to nothing from where we started the year. So what the market’s trying to say is, is inflation alive or not? You know, is it still a big threat to markets? And it’s more of a we don’t know how the market is responding now from, you know, whereas months ago it was. Yeah. It’s not a concern. The battle’s over.

[Sammy Azzouz]: Yeah. So that’s something that’s definitely changed related to market expectations. We’ve discussed before that the rate cut expectations of a hundred and fifty basis points starting in March this year was too optimistic. And, you know, the markets now are pricing in obviously something a lot less, and you mentioned even a slight chance of an increase. So given that you thought the, you know, initial market view was way too optimistic, has anything changed in your mind, and are we too pessimistic right now?

[Bob Weisse]: Reflecting on this, it’s, an interesting exercise. Interest rates are notoriously difficult to forecast. Like, there I saw at a conference I went two years ago, I remember, I think Christopher Davis from, Davis Funds, shared a study where they looked at the Barron’s roundtable. So Barron’s the publication, each year in January, they get, like, the top economists at big banks and ask them a handful of questions. Like, what’s your S & P five hundred year end target? What’s your target for the yield on the ten year treasury? And they took that for the ten year treasury target. And rather than, you know, if it started the year at four percent and someone said four and a quarter, four and a half, they just changed that answer to higher. And if it started at four and they said three and a half a year and they changed that answer to lower. And, historically, through all these roundtable studies of the big chief economists at the big banks, they did worse than a coin flip on the direction of interest rates. And that that that really stuck with me. Like, why are these really smart people who get paid well to make these calls, so poor at it, like, less than fifty percent. And when you look at this year, I think what happens is you get a narrative, and that forms a consensus. And it’s okay. You know, inflation’s coming down. So, like, this year, the narrative was, you know, inflation’s coming down. There will be rate cuts. And markets start to price that in. The expectation of rate cuts behavior starts to act as if those rate cuts are a sure thing. And next thing you know, things get a little too hot, and those rate cuts aren’t coming. So it’s not that the initial narrative was wrong. It’s that it leads to changes in behavior, and then, therefore, you never get it. I don’t know if our listeners follow that, but the point is, forecasting inflation and rates is just very difficult. And you frequently have a consensus view, a narrative that makes sense, but it also frequently does not play out. And part of the reason is because it changes behavior as markets adapt. So it just gets to a little, you know, being disciplined, being diversified, having humility. Nothing’s a sure thing. When you hear there’s gonna be six rate cuts this year, that’s priced in. Well, may happen, may not. So, you know, just, put the crystal ball away when it comes to forecasting inflation and interest rates. That’s more of the takeaway here.

[Sammy Azzouz]: That’s definitely what I heard you say, which is I don’t wanna forecast interest rates and inflation. But it is a good overview. And I I think for investors, what you have to do is understand that regardless of what is expected or not, it’s really how things come in relative to those expectations where if you get disappointments or surprises and I’ve used this analogy before when you go see this movie that everybody’s telling you is just absolutely unbelievable, and it’s good, but you were underwhelmed compared to expectations. You probably think it stinks. Right? And by opposite, if everybody’s telling this movie is horrible and you go see it and it’s halfway decent, you’re pleasantly surprised that it goes. Really good movie. I wonder what was wrong with everyone. And so if you’re expecting a lot of rate cuts and that doesn’t happen, you know, the market can respond negatively. And, conversely, right now, if we’re too pessimistic on rate cuts, you know, the market could respond positively, if there is a, you know, an upside surprise to that. But in either direction, your your bigger point is that’s just good to know so you can understand why your money’s moving. It’s not what you should be using to kinda forecast and make short term trades. Yeah. Well said. It it’s not good or bad. It’s better or worse.

[Bob Weisse]: And we had a six month run. We talked about it on our last podcast. We have some listeners get used, get get prepared for some volatility. We’re not seen around the corner, but, you know, the last six months are not normal. It’s basically just a a low volatility chug straight up and, takes just one CPI report to, you know, scare markets when they’re they’re priced for perfection.

[Sammy Azzouz]: Yeah. And so it’s good to caution individual investors not to try to invest based on a short term forecast. But when you asset allocate, you and your team, and when you choose, for this example, you know, what type of bonds to own, how long term, what type of interest rate risk you’re willing to take, what type of credit risk you’re willing to take, that is a form of a long term forecast. So how do you feel about how fixed income portfolios are positioned right now? Is this, what we’re going through, noise, or is it maybe changing a little bit your outlook?

[Bob Weisse]: No. It’s more noise as far as asset allocate and then investing in fixed income. Overall, yields are at attractive levels, definitely, you know, compared to where they’ve been over the last fifteen years. Our fixed income managers are pretty excited about the opportunities they’re seeing and we’re able to get good yields without taking as much risk as we needed to years ago. So, on average, they’re a little shorter than the benchmark in duration, little higher credit quality than they used to be. So they’re able to get yields five, six, seven percent, with taking less risk than they needed to, say, five years ago. Overall, it’s attractive. And maybe just to add some positivity to the CPI report, I’ll dissect it a little bit. When you look at it, with the economy, there’s goods and services. So in, March, overall, CPI was up point four, but goods was negative point two. So goods like washing machines, cars, things like that, bicycles, were down. It’s services that were up. Services were up point five percent. And then if you look more narrowly, what really drove it, it was really three components of the CPI report. It’s housing, rent of primary residence, and housing has been, stubbornly sticky. We have not had a month over month, CPI, report on housing that’s been below point three percent in years. So housing just continues to be around point four month to month. So point four, you annualize that, you know, Roughly four point eight percent is kind of the run rate. So housing has been sticky. And then there were two other areas that stood out. Health care hospital and related services, that is more volatile. It was one point two percent. And even in our financial plans for clients, we expect health care costs to run above the average inflation rate. And then motor vehicle insurance, really stood out. That was two point six percent for the month. And Yeah. And twenty two percent year over year. Yeah. I dug into that one a little bit, and it’s interesting. What I I read, one of the things is, cars today have more technology on them, like cameras. You get in a fender bender and the cost to replace it, your fender also includes now, you know, the cameras to help see and help with, safety features. So it just costs more to insure. So that it’s a bit of an anomaly. It’s not like you’re replacing the same Toyota Camry, when you get an accident that that you did years ago. So those are three areas, that that spike this report. But overall in the data, there is a lot of, you know, slowing up inflation, like, specifically with goods. Housing to me is the one that they really need to get under control. And, you know, so there was some positivity in the in the inflation report despite the headline number being high. Yeah. Absolutely.

[Sammy Azzouz]: So I was gonna kinda point you there next. The economy seems to be strong. I think it’s very strong. You’ve shared concerns that the labor market needs to soften for inflation to get to where the Fed wants. That was last year. Do you still have that concern, or you do you believe that there’s a lag in the data with things like shelter that will eventually get us where the Fed wants us to be?

[Bob Weisse]: With employment, it’s still a tad hot, but a lot better than, where we were a year or two ago. And shelter, it is a lagging data point, which is, good to bring up. And I I’ve seen studies where they try and overlay where shelter should be based on where housing prices are, and there is a spread between the two. So, basically, you can get to a place where it should be coming down.

[Sammy Azzouz]: That’s one thing I worry about. Again, I don’t have a crystal ball either. I put it away twenty plus years ago. But one thing that’s not in the CPI report is home insurance. And, you know, they have renters equivalent insurance in there. But, you know, our home insurance costs are going up through the roof. Mortgage rates are high. The economy is strong. You know, maybe rents don’t come down in a strong, economy. And if anything, that hope that they will, you know, being the last thing that gets us there, that that could be the what, in my mind, potentially keeps inflation secure.

[Bob Weisse]: Yeah. But housing’s a tricky one because the Fed has this tool of interest rates, and it it’s a very blunt tool. It’s like a doctor prescribing Tylenol for whatever your symptoms are. Sometimes it works, sometimes it doesn’t. And with housing, we have an undersupply, but higher interest rates are making home building more costly. So kind of the solution should be more homes, more construction. But, you know, we have clients who are real estate developers, and they say, you know, the cost of capital is too high to develop right now. So you’re kind of stuck. They’re kind of in their own way. And, you know, some of those people are saying it’s not gonna get better until rates go down, but it’s a catch twenty two. Rates may not go down until housing gets better. But if housing’s not gonna get better until rates go down, you’re stuck. So that’s the one thing, I don’t have the answer for, but it’s something to keep an eye on. It’ll be interesting to see how it plays out.

[Sammy Azzouz]: Yeah. Definitely something to keep an eye on. Thank you, Bob. So another question we’re hearing a lot now is why not just buy the magnificent seven? And for those that are not up to date on their Wall Street lingo, that’s Microsoft, Apple, NVIDIA, Alphabet, Amazon, Meta, and Tesla. And the theory behind that question being, you know, they’ve performed so well. We know they’re, quote, unquote, great companies. Shouldn’t we just buy them and forget about the stuff that isn’t keeping up? And I know you have some thoughts on this, but to tee it up, one thing that this question misses with me is this certainty of which stocks you should own to capitalize on this can’t miss opportunity. And while you have numbers I’m sure you want to share, you can also make the point just by looking at the evolution of the acronym. First, it was the FAANG stocks with one a – so Facebook, Amazon, Netflix, Google, just buy them and, you know, you’ll do great. Then it was FAANG with an extra a to add Apple because Apple started to, you know, to do well. Then it became FAANG m once Microsoft started outperforming. Now we’ve added in NVIDIA and Tesla. And by the way, we dropped Netflix to add NVIDIA because Netflix dropped more than fifty percent since it became part of this can’t miss wave. And on the current list, Tesla’s getting killed. Apple is down almost twenty percent. I don’t know, Bob. Maybe I should have let you start, but the more I dig into this question, the more it seems misplaced to me because there hasn’t been this basket of can’t miss that you, you know, would have bought years ago, and and it’s stable, and and that’s it. The the acronym of changing just tells you no.

 

[Bob Weisse]: That that’s definitely, a good start with the n being the key, I think, to it because it’s gone from FAANG to magnificent seven, and the n’s changed from Netflix to NVIDIA. Netflix has underperformed the market over the last three and five years, but it’s conveniently disappeared from this. And meanwhile, the new edition Nvidia is the star child. So if you’re chasing acronyms, you wouldn’t have bought NVIDIA until recently, and it’s been the one that’s really kept that basket up. Looking at year to date returns, this is through, I think 4/23. Apple, negative fourteen percent. Tesla, negative forty three percent. Alphabet up twelve, Microsoft up seven. So so far those are mediocre or roughly negative returns. Nvidia up sixty. So NVIDIA’s doing great. Amazon up sixteen. That’s pretty good. And Meta up thirty six. So you have three out of the seven stocks really doing well year to date. But NVIDIA up sixty, you put it in a basket of seven other stocks. Even if six of the seven are doing average, you average in a plus sixty, and now the basket looks good. So, really, the story recently behind that, Meta’s had a good run over the last year and a quarter, but it got crushed in 2022. People remember, you know, is Facebook dead and Mark Zuckerberg going talking about the metaverse, and that stock went down a lot, and it it’s basically recovered. And then some, but it had a tough run. So, you know, something to think about with these, there’s a study we’ve shared with clients, and it’s looking at the top ten stocks in the market, the largest ten companies, and the path to get there is a great return. It’s kind of a mathematical certainty. To before you’re one of the top ten companies in the US, as you grow and get there, you have to outperform everyone else. It’s like a, like a horse race, you know, you’re, you’re outperforming all the other stocks and that’s how you get to the top. And the three years before, you outperform the market by twenty seven percent a year, which is phenomenal performance. You’re outperforming by twenty seven percent a year for three years.

[Sammy Azzouz]: That’s why people are asking the question, Bob. What should I just go back in time and who knows? We get it. We get it. You’re in the top.

[Bob Weisse]: But now that you’re in the top ten, how do you do? And three years after entering the top ten, you outperform, but by point five percent. And then five years after and ten years after, you actually underperformed by about one percent. And what happens is there’s rotation amongst the winners. So now you’re at the top of the mountain. And early on, you just got to the top. You keep running your, you’re out, out, outpaced the market by zero point five percent for a little while. But, but after five and ten years, you start to get tired and new winners rotate in and you underperform. So one once you get to the top, it does get to kind of the rule of large numbers. Like, you look at Apple and how they’re gonna run out of people to sell iPhones to. Like, you can only have so much market share. And then with antitrust laws, and just competition and the way the economy works, there’s just more and more competitive forces. So there’s a lot to it. I mean, one other thing when you look at the three stocks that happened well, I guess they weren’t all part of the FAANGs, but Apple, Microsoft, and Google, if you go back to 2013, they had a PE of fifteen times earnings back then. And that was, twenty five percent discount to the market average. So they’ve had a great run for the last ten years, but they started off cheaper than the market. And now they’re all at a premium to the market. So it just the setup that was there ten years ago, it it’s anything but that now. If you look at, like, the total weight of these stocks, they were, you know, the weight of the largest holdings. It was on the lower end, and now it’s expanded. It’s on the higher end, and that just cycles as you have concentration amongst the top stocks.

[Bob Weisse]: Yeah. And that’s a great point. I mean, our conversation here isn’t about not owning them. And to your point, you know, Apple was a cheap stock. It was one of our top holdings in a value strategy that we own, because of that. And I think we own all of these names for our clients in certain percentages. Right? Just, the question is now becoming, should we get rid of everything else and just lock in on those seven? And I think we’ve done enough to chat about why we don’t think that’s a good strategy. But the last thing is it you know, forget about the specific wording of the question. You’re basically asking, Hey, should I dump everything else and chase performance? And that’s never a good strategy. Right? It’s FOMO. And FOMO is not something they teach as an investing strategy in the CFA textbooks. They might teach it in the behavioral investment mistakes section of the CFA textbooks, but they don’t talk about it as a great way to make money. So, anything else you wanted to add on that?

[Sammy Azzouz]: basically, it’s come down to in your mind the story of the two ends. You know, if you had a Netflix, you got clobbered, and you would have missed NVIDIA, which turned out to be the best of them all.

[Bob Weisse]: Yeah. No. And I and I think maybe putting an exclamation point on your last point, chasing performance when you look at read the textbooks and look at all the studies on in investing, whether it’s picking stocks or picking funds, it would be really convenient if you could just invest based on recent performance, but it just doesn’t work. And, there there’s mean reversion. What goes up comes down. And so the idea of just, hey. Let’s look at recent winners and buy those. It just doesn’t work, and time and time again, people do it, and that’s how the average investor underperforms the market.

[Sammy Azzouz]: Great. Well, I appreciate you jumping in to chat with our listeners, this month, Bob, about a couple of interesting inflation reports and a question we’re getting more and more on on some of the biggest names in the market that are getting attention. I know our listeners always get great insight from you, so thanks for joining me.

[Bob Weisse]: Thanks, Sammy.

[Sammy Azzouz]: Thank you for listening to Wealthy Behavior. If you found the conversation useful, please leave a review wherever you listen to your podcast and share this episode so those around you can live a rich life too. We appreciate your feedback and questions. Please email us at wealthybehavior@heritagefinancial.net. For more insights, subscribe to our weekly blog at heritagefinancial.net and follow us on Facebook, Twitter, and LinkedIn. Check out my personal finance blog at thebostonadvisor.com. Wealthy behavior is produced by Kristin Castner and Michele Caccamise.

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