It is a pleasure to share a reflection of how Story views what happened in 2020 and what might lie ahead for 2021 and beyond. With the uncertainty and unexpected events occurring inside and outside the economy and markets today, one thing is certain: it is time to spot some new trends and risks to help us rethink portfolio allocation and performance expectations looking into the future.
But first, here is the most important reminder of 2020: Regardless of one’s political beliefs, one of our favorite market and economic analysts, David Bahnsen, reminds us:
“Markets are the most non-partisan and culturally agnostic institutions you will ever encounter.”
For the record no market or economic analyst knows what lies ahead, and if they say they do, they will fib about other items of significance as well. Story and other solid analysts do not definitively know, but we are astute observers. Story has educated opinions and underlying beliefs that drive our approach and overarching investment strategies. However, we do not expect our clients to agree with us!
Here are a few important observations and opinions reflecting where we are.
What is the Fed doing?
We saw what the Federal Reserve was willing to do during the Great Financial Crisis of 2008/2009, and we are seeing it again in these times. The Fed maintains liquidity by buying government securities to provide liquidity in the banking system. Generally, this liquidity creation by the Fed increases the money supply and depresses interest rates. This is called a “loose, easy, or expansionary” monetary policy – the Fed wants business and people to access money easily during difficult times to “stimulate” the economy. This is great for risk markets (stocks) because the Fed seems to be willing to step into markets directly to avert potential economic catastrophe. The Fed appears to desire to stay the current expansionist course until 1) they decide not to, or 2) they discover that the effectiveness of their monetary policy no longer works as anticipated. This has been a problem in other developed countries like Japan where their Central Bank has tried for decades to ignite inflation and have thus far been unsuccessful!
Does this historic economic environment cause Story to re-think what drives returns and supports value creation? Yes! We believe prospective clients should too.
We believe that credit will remain loose in 2021 and beyond and that there may be “bubble” developments in certain sectors where low interest rates and loose credit could overstimulate activity such as within the real estate sector whose bubble will, as they always do, pop at an unknown time…again.
What’s going on with interest rates?
Interest rates will be zero-bound (0-2%) for the foreseeable future (Fed Chair’s Jerome Powell’s recent comment is that rates will rise “no time soon”). What are the implications of these low rates? Well, our clients’ portfolios will not see a MN municipal bond ladder anytime soon unless the client is looking only for safety, security, and liquidity. Yield to Maturity collapsed last August (2020). This milestone was pretty much ignored in 2020.
A related point of interest regarding Fed intervention: if the Fed had not become the buyer of last resort in mid-March 2020 for various bonds and other “fixed-income type” instruments, bond funds and bond ETF valuations would have collapsed. Leveraged market participants were running for the exit in their bond positions to raise needed cash for margin calls and there were practically no buyers…except the Fed. Easy question: What’s an asset worth when you need to sell and there are no buyers? In our opinion the Fed saved bond fund and bond ETF valuations!
Of necessity, financial advisors have had to admit (or soon will) that bonds have arrived at a place where they will no longer contribute much to portfolio returns. Most of the recent realized appreciation in bonds has been generated due to rising bond prices derived from declining interest rates (see graphic). However, we believe that this falling interest rate “gravy train” is likely pulling into the roundhouse for maintenance. Not forever, but for a season. Really… How much lower can rates go? Here are some examples:
- What’s the savings account interest at major banks?
- One tenth of one percent!
- What about the yield on 10-year Treasuries?
- One percent +/-!
- What happened to the FDIC insured rates at online banks which used to be above 2%?
- One half of one percent.
Fun Fact: Do not be fooled by an advisor who quotes the coupon rate of an individual bond. A $50,000 MN Muni bond with a 5% coupon sounds nice on the surface. $1,250 coupon payments twice a year is certainly better than a poke in the eye with a sharp stick. Here’s the rub: you will have to pay a 20%+ premium of $60-65,000 to purchase that 5% coupon municipal to get only $50,000 back at maturity plus coupon payments. That’s a 1% Yield to Maturity on a bond with 8 years until maturity before the advisor fee which can easily bring you a 0% yield after fees.
All this simply points to the value of obtaining a second opinion on BOTH the fixed income and equity sides of your current portfolio. Please do not put your portfolio on autopilot. If a private jet on autopilot depressurizes in flight (like the economic anomalies discussed here) and no defensive action takes place, the jet (your portfolio) will continue to fly until it runs out of fuel and then gravity takes over. Entropy wins.
What about inflation?
Because of the alignment of fiscal (Congress’s taxation and copious spending policy) and monetary policy (the Fed’s current loose money policy), we believe that inflation will remain low – in the 1-3% range. There will likely be sector specific price aberrations based on short-term supply and demand tensions (for example, housing and energy), but overall, wage and most price inflation will remain low despite what many folks fear.
How will zero-bound interest rates impact equity investments?
Theoretically, with the “risk-free” rate of return (generally, the 3-month Treasury Bill rate) near zero percent, the risk premium for investing in large-cap growth companies (who pay no dividends let alone inflation-beating increases) might be expected to return less than their rolling 10-year averages looking ahead. Again, Story doesn’t “know” this, we simply believe clients might consider alternatives.
We have seen that low interest rates and loose monetary policy have pushed the PE ratios of large cap domestic growth stocks into historically expensive (read: risky) territory. On its own, this is not a signal to exit equities; market timing never works in the longer term. However, with 23-27% of the S&P 500’s value composed of 5-7 technology company names, perhaps a reexamination of one’s allocation is in order. To put this in perspective, our clients are already heavily concentrated in their employer’s single security. Why should they take on more risk in an S&P index fund that is super concentrated in 5-7 technology companies?
A few thoughts considering these economic conditions:
- Perhaps this is not the season for index investing
- Perhaps a rotation into value stocks might be in order
- Perhaps one ought to consider leaning into companies that produce an abundance of actual free cash flow who share it with their shareholders instead of companies who “hope” to generate free cash flow in the future. It is possible to de-risk while remaining in equities
- Perhaps a renewed focus on investments that deliver yield as a major component of overall return instead of counting on declining interest rates to deliver total return in fixed income or further expanding PE ratios to justify increasing stock valuations
- Perhaps a rotation into small and mid-capitalizations is in order…maybe even emerging markets
If you are already a client, you get the picture. For those who are not clients please consider getting a fresh perspective. You do not have to leave your current advisor, just call us to obtain a fresh perspective. There is no cost to do so beside an investment of your time and we will respect the value of your time.
Another Fun Fact: A client does NOT have to agree with our worldview.
Every single portfolio we construct with a client is completely customized based on each client’s desire for risk, return, timeframe, and an entirely deep set of other overarching circumstances that are unique to each individual client’s family. How do we do this? First, every client has a highly detailed, cash flow-based personal financial model developed for them. Second, we do not allocate according to Risk Tolerance, but rather to each client’s desired Risk Preference. Click here to read more about what this means.
A client does not have to abide by our beliefs to enjoy our investment counsel because portfolio construction is a collaborative effort. Our clients are brilliant people, leaders of leaders. We provide context but, in the end, we take direction from client preferences. Story does not have a “one trick pony” asset allocation that a prospective client must use to ride with us. We ride with our clients.
If you have questions about our outlook for 2021 or you want a second opinion on your portfolio, call us at 952-657-7205 or send us an email at email@example.com and the Story team will get back to you right away.
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This report was prepared by Story Capital, LLC and reflects the current opinion of the firm, which may change without further notice. This report is for informational purposes only and is not intended to replace the advice of a qualified professional. Nothing contained herein should be considered as investment advice or a recommendation or solicitation for the purchase or sale of any security or other investment. Opinions contained herein should not be interpreted as a forecast of future events or a guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's portfolio. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.
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