It’s been a while (or has it?) since our last client-specific email update. As you might imagine, though we have not been formulating our thoughts “on paper” as frequently, our brains have continued running 24/7 trying to make sense of this brave new world we now all find ourselves in. A couple of months ago, I made the decision that all “auxiliary” business activities (these updates included) would be suspended indefinitely – until such time that we had accomplished a singular goal:
Universal agreement (within our firm) on the “perfect portfolio” for the current environment.
The portfolio should properly reflect both short and long-term opportunities and risks present in the current environment. It should be easily modified based on each client’s specific profile. It should be constructed for the long-term, yet compatible with shorter-term trends and events. And while we of course realize that the “perfect portfolio” does not exist in reality – most certainly in the reality we now find ourselves in – we wanted it to feel that way…right down to the last tenth of a percent.
This is not a new exercise. As you might (and should) expect, this is what I have been doing for close to three decades now (seriously?!) – analyzing the investment landscape and creating portfolios around it specific to client long-term goals. Still, this time felt different as we got into it…
Days turned into weeks. Spreadsheets with return forecasts for countless scenarios were created. The far wall of my office was turned into a glass, dry-erase board so as to permanently organize thoughts in front of my face. Additional TVs were installed in the hope that we would more easily catch the rare occurrence when the financial media had something/someone relevant to present (that was a waste of money).
Weeks then turned to months. Our daily meetings were now getting more combative as we revisited each previous days’ discussions, adding information that we may have absorbed the night before while pouring over newsletters, Twitter, analyst reports and the like. Yet, at the end of each day, we would frustratingly find ourselves feeling no closer to our stated goal than we had the day, week or month before. Sure, we had added or subtracted a few positions here or there – but we were far from feeling like we had agreed upon that “perfect portfolio” for the current environment.
Then this week, I finally realized why this exercise was seemingly so difficult this time around. As we have stated repeatedly, we have always been of the belief that clients should have an expectation that their wealth advisor is managing their own money using the same process they use for their clients. In other words, I should/shouldn’t be doing something with your money that I would/wouldn’t be doing with my own. I assume most reading this would appreciate that sentiment.
I call this my “look myself in the mirror” test – and it’s at the very top of my career objectives list (and will remain as such for as long as I am in the business). If I wouldn’t do it with my own money, I’m not going to do it with yours – unless otherwise directed by you. End of story.
Now, to the extent you pay attention to such things, you may have noticed that the S&P 500 / NASDAQ indices have remained largely the “only game in town” when it comes to returns. This has become near-cemented now that treasury rates are effectively zero, and as flows into passive investments have continued to grow. But as this has continued, valuations of these indices have become more and more stretched – while the economic reality around them has become more and more precarious. We have talked about this at length over the years, and will continue to do so – but that’s for another update.
Getting to the point, I realized the combination of the above two discussions was the precise reason we were not getting anywhere. I was trying to pass the “look myself in the mirror” test, while incorporating investments that would make it impossible for me to do so. There are times when the two just aren’t compatible, and this is definitely is one of those times.
Importantly, I also realized that I was working backward. As it became apparent that we were reaching the same conclusions (or lack thereof) day after day – albeit while analyzing more and more information – it dawned on me that the best thing I could do was to write. I needed to organize all these thoughts on paper, as often that exercise alone will provide clarity. Added bonus: the organization of these thoughts on paper would allow for maximum transparency with all of you as to what and how we were thinking – something we always strive to accomplish.
As such, for better or for worse, the quarterly update has been revived….
And I could think of no better format for this particular update than bringing back the “What We Know, What We Think We Know, and What We Know We Don’t Know” for a third time – first since 2018. This time, we are adding astericks to each category – as anyone claiming they know anything with certainty at this juncture is being disingenuous at best. So, I have added an alternative description of each category as we go. I will also be adding a brief description for each observation in terms of what it might mean for various asset classes where appropriate.
I will intentionally be (attempting at least) keeping these descriptions brief. For the few that truly look forward to these updates – fear not – the mother of all updates will almost certainly be coming sometime in the next 12 months, or as soon as we have the proper time required.
With that, let’s dive in…
What We Know
(In other words, that of which we are highly convicted)
The Fed is going to keep printing money – and a LOT of it.
I don’t know how to keep this one brief – we could write a book about it. But I promised, so let’s give it a go. The Fed knows that they are already at the point of no return. There is SO much federal, state, corporate and personal debt out there – they simply don’t have a choice. Additionally, they have no interest rate policy left to work with – they are already at zero. Finally (and related), pension funds - and the investor class as a whole - are dependent on it.
This is woefully inadequate in terms of specifics, but I promise, there will be so much more to come in future discussions….
From an investment standpoint, this is sole reason we like gold, silver and broad-based commodities so much (long-term) compared to other asset classes. While certainly good for stocks (see the past decade), we view it as much too simplistic to say, “Fed printing guarantees stocks keep going higher”. Importantly, we also acknowledge we may be wrong on that front – anything is possible at this point.
Generally speaking, financial assets are now all correlated.
This is not talked about near enough in our opinion. As the Fed continued inflating asset bubbles over the past 30 years, treasuries served as a great hedge during the busts as interest rates fell further. With treasury rates near zero, portfolios no longer have a reliable hedge. In other words – and generally speaking – all assets now “move in the same direction”, just to varying degrees.
This is dangerous, and I don’t have a single “nice” thing to say about it. We always view “diversification” as one of the most important principals of investing – having investments designed to “zig” when the others “zag”. We have a bad feeling that investors are going to find out just how little traditional “diversification” helps the next time around. It’s all about correlation – and it needs to be discussed/addressed more….
If the Fed is successful in their quest to “remove risk” from financial assets in the intermediate term, high yield spreads will eventually reach historical lows.
This is a simple function of interest rates – and a Fed removing risk. In an environment with so many investors seeking yield – and no conservative yield to be found – assets will flow to the “next best thing”. We witnessed this over the past 10 years, and that was before interest rates were zero and the Fed was actively buying junk bonds – so not rocket science as far as we are concerned. This would likely apply similarly to emerging market debt and other asset-backed income securities.
So back up the truck, right? Not necessarily. You’ll note that the statement began with an “if”. Without the Fed, we wouldn’t touch the space with a proverbial ten foot pole – given the amount of debt out there and the economic backdrop. But given that spreads are still historically elevated – and the fact that the Fed is involved – the space should not be ignored in our view. Still, one shouldn’t ignore the “if” in there….
The economy – and corporate earnings as a result – face more significant headwinds than they do tailwinds.
Headwinds (negative) to corporate earnings:
Threat of higher corporate (and individual) taxes
Trade War with China
Scrutiny / inability on future share buybacks
Elevated unemployment
Already at zero interest rates – can’t lower to induce more spending
Second Wave of Virus / Re-Opening
Social Unrest / Election Uncertainty
Tailwinds (positive) to corporate earnings:
The Fed
Modern Monetary Theory (in other words, the Fed)
Layoffs / Cost Cutting (which then becomes a headwind for economy)
Technology
The Fed
This remains – by a large amount – the most perplexing part of today’s market. If stock valuations are stretched (they are), then in order to revert, you need one of two things to happen. Either stock prices fall to better reflect expected earnings, or the earnings grow significantly faster than the stock price moving forward. Somehow, we have stock prices rising - from already elevated valuations – with earnings facing prospects described above. Either we are badly missing something in our analysis of future earnings, or something is way out of whack. Particularly in this case, let’s hope we are missing something….
Round Hill has added yet another member to the family.
You know what they say – always save the best for last. We are thrilled to announce that Dave and Constance welcomed Gabriella Maria Christina Swanson – already lovingly known as “Gabby” - into this crazy world on September 27th!
And I am confident in knowing with certainty that baby Gabby is blessed to have Dave and Constance as her parents….
What We Think We Know
(In other words, what we view as more likely than not)
The “Democrat Sweep is bad for markets” narrative is misguided.
OK, before the Trump fans start on me, nowhere in that statement did it read “Doug wants a Democrat sweep”. Now that we got that out of the way…
If there was a single thing I would like to debate with one of the Wall Street yahoos on CNBC, it would be this. There are few things more entertaining than listening to some analyst tell us for 20 minutes why we should be backing up the truck to buy stocks simply because “the Fed is printing money” – only to follow it up by saying “the only risk we see is a Democrat sweep in the election”.
You simply can’t have it both ways. If the main driver of stock prices is the Fed printing press, there is nothing in the world that would make it go “brrrrr” like a Democrat sweep of this election. Think it through. A Fed president coming on 60 minutes to plead with Congress for the ability to print more money. Couple that with a political party whose main platform is free education, free health care, open the borders – and a “$100 trillion green new deal”. I don’t know that the existing printing presses could even handle the demand….
Conversely, the REPUBLICANS are the ones (supposedly) wanting to slow the spending and curb the deficit. So, which is it?
I’m not even offering an opinion. As I have made clear, it is our belief that the major indices are trading much more as a Fed-induced casino then they are any sort of free-market price discovery based on valuations – so I don’t know which would be better or worse. All I know is that the narrative itself makes zero sense for the reasons described.
Valuations still matter. Or, at least, they will. I think.
This statement really belongs in the “What we know” section – but we moved it down a notch purely as a conversation about timing. And since it’s been some 15 years since valuations (or value investing) has meant much of anything in the face of flows into passive investments – it sure feels difficult to state that “we know it”.
In terms of investments, there are two things to take away from this observation. One is that – in every other time in history – buying assets with overly expensive valuations has proven painful in the end. Second, and more important to this discussion, there are many asset classes that we would historically prefer owning at these valuations than the S&P 500. But, while likely more prudent to do so in the end, it won’t be any less frustrating for as long as the current environment persists.
As many much more seasoned than I have repeated over the years – and as we have all witnessed for some time now – valuations can stay elevated (and get more so) for long periods of time. This is called periods of “speculation” in the industry. I call it gambling, but it’s largely one in the same.
Call it what you will, this observation really gets to the crux of everything we discussed in the opening of this update. Most returns are increasingly limited to a couple of the most widely held indices – which by construct really means only a handful of giant tech stocks. These indices are very expensive (unattractive) in terms of valuations from both a short and longer-term perspective – even in the face of deteriorating economic and regulatory prospects going forward. And now - for the first time since the Fed started blowing asset bubbles some thirty years ago – returns on virtually all cash/conservative income are at or near zero.
So, on one hand, we can remain significantly underweight the expensive stocks, then wait for the valuations to come in as they have in every other instance. On the other, we can acknowledge that all the money continues to flow into these same names due to passive investing – and we roll the dice assuming that things like earnings growth no longer matter, so long as the Fed keeps on printing. You know, that this time is different because xxx…..
We don’t know the answer in the short term, but we think we know in the end.
There will be significant movement toward replacing the US Dollar as the world’s reserve currency.
You can call this a “tin foil” statement if you wish – but I’d recommend against it. The signs are all there. Going back to our first segment, the Fed is going to be printing and printing a lot. The rest of the world – including China – knows this. Central banks around the world have purchased more gold in each of the last 3 years than they had at any other time in the last 50. And if neither of those were reason enough for concern, China is ALREADY trying to take payments in non-dollar currencies with other nations.
Please note that we didn’t state that we think “they will be successful” in this movement. Still, the growing evidence of it becoming more of a mainstream conversation – along with any other geopolitical consequences of such attempts – remains a troubling tail-risk for the economy and financial markets moving forward.
What We Know That We Don’t Know
(In other words, anyone stating otherwise with certainty is nuts)
Inflation or deflation?
Another of the conversations that takes up a good majority of our daily discussions – and one whose answer will surely have enormous impacts on various asset classes going forward. This too warrants about 20+ pages of analysis on its own – saved for a standalone update down the road. For now, let’s look at the arguments for each:
Arguments for Inflation:
The Fed printing money
The Fed finally acknowledging they are actively trying to create inflation
Willingness of politicians to spend (especially Democrat sweep)
Universal Basic Income (UBI) already been “tested” (the $1200 checks)
Modern Monetary Theory (MMT) more widely accepted as legitimate
“Inflating away the debt” becoming the only realistic option
Arguments for Deflation:
The massive amount of debt out there
Japan as an example
Technology / A.I.
Fed “loses control” of the markets
Economic / GDP weakness
Again, way too simple of an analysis. But let’s instead analyze what either means – starting with one simple truth:
Money is nothing more or less than the products and services you can purchase with it.
So, if you are expecting prices of goods and services to increase significantly (inflation), you will want to be invested in asset classes better suited for growing your money to keep up with the rise in prices. Gold, silver and commodities in general would be the most direct (assumed) way of doing so – followed by stocks (to the extent they can effectively manage their costs). On the other hand, cash (at “zero” interest) would be the worst place to have your money. If your cost of living was rising at say 5% per year – but your cash was earning 0% - you are effectively losing 5%/year on your money (remember, it is nothing more or less than what you can purchase with it).
On the other hand, if the economy and markets were to collapse under the weight of all of this debt, we would expect the cost of goods and services to decrease significantly. In this case, cash (or other “safe haven” income vehicles) – even if earning nothing on it – would likely be your best performing asset class.
In this case, we would expect assets such as gold, silver, commodities, stocks – really any “risk” asset – to lose significant value. Cash, on the other hand, would not only keep it’s value – but would also purchase even more as the prices of goods and services declined.
As you will recall from our countless updates previously, we have one universal goal on behalf of our clients. That goal is to do everything in our power – through proper planning and implementation of investment strategies – to ensure that our clients do not outlive their money. In order to accomplish this, we have to attempt to properly balance risk/return potential – in light of interest rates that are non-existent – due to a Fed doing whatever it is you want to call what they are doing, and leading to what we are discussing now.
Unfortunately, we cannot know which of the two will ultimately occur – nor can we know when. What we are more confident in is the idea that the Fed has put us in a spot where one or the other is going to show up in significant fashion. Our goal – going back again to the opening of this update and as mentioned above – is to figure out how to best protect against either outcome, consistent with your individual needs. Now that I think of it, this is the proper explanation of the “perfect portfolio” which is proving to be such a struggle…
Finally, I will say this. While we are acknowledging that we cannot answer the inflation/ deflation question with certainty – we do lean toward the inflation camp. For one, I am guessing every single person reading this has found themselves at some point in the last 6 months thinking, “come on man - these xxx bills are getting expensive!” In other words, it’s already here. Second, regardless of the outcome of this particular election, it is increasingly clear that politicians (both sides) and now (openly) the Fed have moved toward accepting MMT. In other words, “just keep printing, just keep printing…” (sung to the tune of Finding Nemo). It seems almost impossible to reverse course at this point – and even if they wanted to – we believe they would find out quick that the results would be too devastating. Just ask Jay Powell, via 2018….
Finally, a Democrat sweep of the upcoming elections – assuming they plan to implement their stated platform - would be the first time in a long time where politicians were ready and willing to spend unlimited amounts of money, with the Fed ready and willing to print it for them. This. Is. Important. On many levels. Only works with a sweep. If Biden wins, but GOP holds Senate, that would actually be the worst-case scenario for the MMT (just keep printing…) believers. In terms of fiscal responsibility, most Republicans are only Republicans when a Democrat lives in the White House. They will be in no rush to spend on behalf of Mr. Biden.
In fact, a Biden win - coupled with a GOP controlled Senate - would be the greatest chance for significant deflation in our view. Mountains of debt with no fiscal stimulus (nice way of saying “handing out money”) is a recipe for disaster.
But Biden, TV Chucky Schumer, Pelosi and AOC – along with Jay Powell and his newfound appreciation for what his predecessors left him? Whoa Mama! That printing press gonna go brrrrrrrrrrrr….
Attempted humor aside, the inflation vs deflation question is one of enormous consequence moving forward, while frustratingly difficult to predict due to conflicting variables. The election results should give us additional clarity on what may be coming on this front.
Will the dollar strengthen or weaken from here?
This is extremely similar to the “inflation vs deflation” pondering, as they are largely one in the same with the dollar still currently the world’s reserve currency. The argument for the dollar significantly losing value from here (a heavily favored narrative by many) is simple – it’s supply and demand. When you increase supply of anything by a large amount – in this case, due to the Fed printing money for more “goodies” – the value of said item will fall. Given our belief that the Fed will be printing previously unthinkable amounts of money in the coming years, you would think we would share the popular opinion that the dollar is about to get crushed.
But, what if the rest of the world is printing just as much (if not more) as we are? They are, by the way. Also, how does this play out when we are the reserve currency, while the rest of the world is not? I can tell you from experience, thinking that one through is enough to make your head explode.
Similar to the inflation discussion – and consistent with its inclusion in this section – the answer is that no one really knows for sure. Also similar is our belief that if we were forced to decide between one or the other, we would agree that the dollar is likely headed for weakness – but it remains far from a foregone conclusion.
Man, we sure wish we could answer this question with certainty. It would make our long-term conviction in precious metals as well as broad based commodities that much stronger. Additionally, there has been an almost eerie inverse correlation between virtually all financial assets and the dollar of late. And as you will note from above, virtually all financial assets have now become correlated. I’m not so sure how strongly I feel about the inverse correlation between the dollar and ALL assets – but we are much more convicted as to what it would mean for gold, silver and commodities….
Will my kids ever be allowed back into a classroom?
Do you honestly think I’m crazy enough to expand on this one? I’m not, so I won’t. But it belongs in here because, at this point, I don’t know what new information could come out that would allow this “award-winning” school district in Naperville to get the kids back in school.
(Yes, that’s in there just in case this reaches anyone of influence in the Naperville school districts. Call me, and we can chat – I’d love to hear the explanation….)
Will the Fed successfully be able to put a floor under markets in the future by directly “buying the indices”?
First thing to note – we are not asking whether or not the Fed will ultimately request (and be granted) the ability to buy stocks directly as part of some “QE 1,227” – that’s a foregone conclusion in our minds. As discussed previously, the Fed is now openly aware that we have reached the “point of no return” in terms of keeping markets elevated and liquid. The real question is whether or not it can work.
On one hand, we have an example already in Japan – as they have been doing so themselves for nearly a decade. As it stands, the Nikkei 225 sits more or less at the same level it did in 1991 – so not exactly what one would call a success. At the same time, and to be fair, the index is up more than 100% since they began the program in early 2013. Now, is that performance more indicative of the economy and earnings, or the Japanese central bank involvement? As is always the problem when central banks start interfering with free-markets, there is no way of knowing for sure.
It should also be noted that we are not Japan, on many different levels. So, a direct comparison cannot reasonably be made in thinking through what it would look like here. Still - while true that this is being inserted in here partially to vent my hatred for the Fed turning free-markets into casinos while taking away your ability to earn reasonable returns on more conservative investments – this is a very important question to ponder. If we were certain that the Fed can and will effectively remove all risk from markets going forward, it would be foolish to maintain a more conservative investment stance for the sake of risk-management. If the Fed can remove all the risk, what risk is there to manage?
I promise you, the minute we have the answer to this question, we will adjust your portfolios accordingly. Please, don’t hold your breath….
I’m on day two of writing this, and about ¼ the way through everything on my list. For the sake of everyone who has read this far, I’m going to cut it off here as I think I have hit the most important points. Many of the others are “subsets” of what has been discussed above.
Unfortunately, as I type this, I cannot communicate that this exercise has gotten me any closer to that “perfect portfolio” than when I started. But at the very least, I hope I have been able to shed some light on the types of conversations that we are having around here on a daily basis…
Along these lines, we are going to be changing up the traditional year-end rebalancing of accounts/review meetings this year. In every other year, we do any rebalancing and tax-loss harvesting in the months of November and December, then begin annual review meetings in January. This year, I will be combining the two – having a review meeting with each of you, then rebalancing after we meet. And yes, our “meeting” can be on the phone or here in the office – entirely based on what is most comfortable for each of you.
The reason for this change is largely described in this update. Mainly, there has never been a time in my career where the discrepancy between investments that we deem to have the best risk/reward attributes for the long term – and the major indices that you see on TV each day – has been this wide. What that means is that, especially in the short-term, it can lead to equally wide discrepancies between what you “see on TV”, and what you see on your statements.
Additionally, as I have hopefully described, the investment world as we know it has changed rather dramatically in the past 6 months. Fixed income and cash are no longer a viable option for reasonable returns, nor are they viable as a hedge as they have been traditionally. This means that, in order to achieve the same returns as in years past, we have to assume greater risk. Or conversely, in order to manage risk in the same manner we had previously, we have to be willing to accept lower return expectations.
Unprecedented Fed intervention, along with the continued and increasing role of passive investing, has created a “new environment” where valuations “don’t seem to matter”. Well, maybe, for now. We will have to wait and see if “this time is truly different”. Either way, we remain convicted that these actions have created abnormally elevated levels of risk going forward – though importantly that the “risk” created could be either up or down directionally for the markets, as confusing as that may sound. This ties directly into what remains, in our view, the most important question of the day moving forward – inflation or deflation?
With all of that said, we can analyze, dissect, rant and rave all we want. At the end of the day – with investing as with life – we must always play the hand we are dealt. So, this is what we will continue to do, while acknowledging that this particular hand will likely require some thinking outside of the box.
I appreciate your taking the time to read this far, and look forward to our meeting where we will discuss all of this and more – but in terms of what it means to each of you and your long-term goals.
Of course, we welcome and truly appreciate any questions and feedback in the meantime….
And we can think of no more pertinent time than now – this blessed year of 2020 – to thank all of our clients for the trust and confidence you have placed in Round Hill.
Douglas Brymer David Swanson
President & Wealth Advisor Principal & Wealth Advisor
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.
All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.
Equity investing involves risk, including loss of principal. No strategy – including tactical allocation strategies - assures success or protects against loss.
Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. There is no guarantee that any investment will return to former valuation levels.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major indices.
The NASDAQ Composite Index measures all NASDAQ domestic and non-US based common stocks listed on the NASDAQ Stock Market. The market value, the last sales price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the index. You cannot invest directly into an index.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
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