On May 18, 2022, Plancorp CEO, Chris Kerckhoff, sat down with Chief Investment Officer, Peter Lazaroff, for a client Q&A regarding recent market trends. We compiled a transcript of that conversation for those who could not attend.
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Chris Kerckhoff: Thank you to everyone who has joined the call. We started doing these Q&A's in March of 2020 as a result of a lot of client questions that were coming in around the early days of the pandemic, and we found it to be extremely useful. Even more importantly, clients found it extremely useful.
We were doing these almost weekly for a while, but we’ve pared that back a bit, so it would be great to hear how often it would be helpful to hold these Q&A sessions.
Normally we would have Brian King, our Chief Planning Officer, or one of our other CPAs joining us to talk about a potential impact of tax policy. But the likelihood it seems that any kind of major tax policy is going to pass before the midterm elections seems exceptionally small.
And that allows us to really focus our time today on all things related to the markets, which I think is really at the foremost of most people's minds when they think of what's going on in finances today.
So just to state a couple obvious points, the Fed has already started rate increases. They've increased rates twice now, for a total of 75 basis points since the beginning of the year. Chairman Powell spoke yesterday about just how dedicated the Fed is to fighting inflation through (1) raising the Fed funds rate and (2) reducing the size of their balance sheet.
Most experts and analysts believe that the Fed will raise rates to around 3%. As for their balance sheet, it has grown by trillions of dollars during the pandemic through purchasing of bonds. And they're going to start allowing some of those bonds to roll off their balance sheet where the maturities will happen. So there's not necessarily selling anticipated yet from the Fed. But they are going to let that balance sheet shrink kind of from a natural standpoint.
Why is this important? Well, I think it's important in a few ways. One, as Chairman Powell spoke very explicitly yesterday, for the first time in quite a while the Fed is squarely focused on just inflation, even to the point where they've admitted that unemployment is likely to rise a bit as interest rates go up, which is something. Really, if you think back to three years ago, you'd be shocked to hear the Fed say something like that. And he even admitted that it's possible that the Fed actions could push the economy into some level of recession.
Now, a comment on recession, it's always important to note a couple of things. One is that markets, both bond markets and stock markets are forward looking in nature. So everything I'm talking about today is, is already priced into the market.
The market heard all of this yesterday, they've been hearing from Chairman Powell and from many other Fed officials for months and months now. So if there is a positive note to all this, it's that the Fed messaging has been very transparent and as forward looking as, I can remember in my career. It's also been consistent across the board. There's been discussions whether or not rate increases would be 25 basis points as high as 75 basis points. But really no one doubting the fact that there will be continued, interest rate increases. So much so that the 10 year treasury, even after the 125 basis point rate increase, you saw the 10 year Treasury jumped significantly, to right around 3%, where it stands today. So doubling where we're finished the year just about.
As interest rates rise, I think of that like a rubber band being stretched out. When you have low interest rates, you have a lot of slack in the system. News and surprises such as the war in Ukraine and additional lockdowns that have happened in China, those tend to get absorbed when you have really low interest rates. As you tighten monetary policy and interest rates rise, that rubber band gets pulled. And so you see a lot more volatility when news breaks. That surprises the markets. And that's definitely what we've seen this year.
As I'm sure all of you are aware, not only are stocks off to a very rough start – the third worst start to the year for the S&P 500 – but bonds are actually off to their worst start of the calendar year with the U.S. Aggregate bond index down about nine and a half percent as of April 30.
History would tell us that just because bonds and stocks start off the year poorly doesn't mean they're going to finish that way. In fact, if you look at this data from BlackRock, you can see that after the 10 worst starts to a calendar year for bonds, 10 out of 10 times they've actually had positive returns for the following eight months. I'm not suggesting that's going to be the case this go around; but with the idea that markets are always looking ahead, the market is clearly priced in the interest rates that the Fed has already discussed.
If the Fed pushes interest rates even higher than that three-percentage point, I would anticipate we would anticipate that that's going to put additional downward pressure on bonds. And conversely, if the Fed were to stop short because they see inflation start to tick down in advance of what they expect today, you may see some upside to bonds. Not a lot, but some potential upside.
On the stock side, we all know that stocks by their very nature are volatile. Looking at the 10 worst starts to a year for stocks, 80% of the time the next 12 months had positive returns with an average return of over 24% for the 12 months after that rough start to the first four months of the calendar year.
One thing I think we do believe is here to stay is the volatility. And it's always a little bit challenging, I think, to have a year like we're having this year on the heels of the year like 2021, which had historically low volatility and only seven trading days in 2021 experiencing up or down movements of two percentage points. And so far this year, as at the end of April, we've experienced 12 have such days. And I haven't counted up in May, but we've had two of those days just this week, so we've already more than doubled those extremely volatile days that we had in 2021.
For our portfolios that have tilts towards value stocks, value has held up better than the broad market, and certainly has done better than growth stocks in the cycle, which is fairly typical, where we are in this particular interest rate cycle. But there's no doubt that we're in we're in challenging and volatile markets. So what we think about then is really focusing on what can we control.
You hear us talk all the time about the fact that we structure portfolios for our clients, to be able to be successful through these volatile times, we do that by focusing on a cash reserve for clients having an allocation to safe short term bonds.
So I mentioned the aggregate bond portfolio, down about nine and a half percent, our bond portfolio is down less than that this year, somewhere in that six, five to six percentage point, range. Again, I know that's not a positive. But to be honest, it's hard to find any positive asset classes in this market today, outside of commodities, which are going up as we see inflation rates rise.
So we structured things so that clients can have those safe asset classes and ride through these volatile times in the stock market. Our trading team is actively looking for opportunities to harvest losses, so to kind of make lemons out of lemonade when the markets are down. And of course, to rebalance back to target allocations, which really forces that discipline of buying stocks when they're at lower prices. So that when they do rebound, we've got the benefit of having more shares in our pockets.
So with that, we can open it up for any questions. We’re really here to focus on topics and specifics that you would find helpful. If there's something specific to your exact portfolio, we would ask, we'll take those questions, but we will likely refer them to your wealth manager just so you can get a very individualized answer. But anything broadly about the state of the economy, inflation, the markets, we're open to, to any questions
Peter Lazaroff: I'll remind people that you can submit a questions in the Q&A tab or the Chat. While we wait for some questions to come in, we’ll talk a little through some of the charts in this blog post we published last week.
We are always going to say you should stay the course. But that doesn't mean we're ignoring what's going on in the world. Suggesting that you stay the course doesn't ignore the fact that things could get worse.
But as Chris mentioned, the market is does a pretty good job of pricing in new information. When you see those big pricing swings, that's really just market participants changing their view of future profitability.
These downturns are very normal and it’s sometimes surprising to see how often that you do end up back in the black by the time the year is over. So the first chart goes back to 1980, in part because that was all that I could fit onto a chart and still make it visible. No magic beyond that. But in 32 out of 42 years where there's a downturn, we see that we ultimately finished positive. And that average decline is 14%.
As of today, we're approaching the 20% decline threshold, which is the point where people call it a bear market. Those these definitions are somewhat arbitrary, but we're at a magnitude of losses now where we thought it was reasonable to hold this Q&A, whether it's officially a bear market or not, just because it's nice to see some of the history points.
The other thing about staying the course: The longer you hold, the more that the range of outcomes narrows. So just looking at the second chart in that blog post, you see the different time periods of the S&P 500. And you see in any given year, the S&P 500 can be down 43% or up 54%. So a 97% spread in the range of outcomes. If you look at two year periods, the range of outcomes narrows down to 76%, out three years ago, range narrows, again to 58%, and so on, and so forth.
Obviously, when you go to a multi decade horizon, stocks are pretty consistent with the returns they provide. And one of the things that we do in the financial independence analysis, which really is reliant upon that assumption that real returns the returns stocks or bonds will earn after you back out inflation tend to gravitate towards their long term average.
As we're talking about all these different market things, I would think that you would find it useful that we do continue to monitor these situations, we do continue to update our models and make sure that our assumptions are strong. But ultimately, financial theory tends to work really well in the long run. It's just moments like this, that the long run is really feels like an eternity to live through.
If you look at this third chart from the blog post, these are real returns – so that’s the nominal return minus inflation. These light blue lines are one year real returns, this darker blue is 10 year returns real returns, and the red line is the average. And if I put 20 year returns up here, they really hover all over the average, but it was arguably a little too hard to see, which is why I didn't include it.
When we talk about our financial planning assumptions, we assume a 7% real return on stocks, global stocks (so that’s net of inflation) and we assume a 1% real return on bonds (so again, that’s net of inflation).
I think that's helpful to keep in mind, in part because the S&P 500, real return since 2009, is 14.34%. Look, you can't have above average returns forever. That's what averages are all about. So living with these negative return periods is sort of the cost of the higher expected returns from stocks. But also I think you have to zoom out and remember that those returns you've earned over the past decade plus those do count, too.
We get this is not fun to sit through. But you don't want to lose sight of the longer-term returns you’ve captured.
Chris Kerckhoff: I think this idea of the real return is something that we likely don't talk about enough. But as we're in a period of the highest inflation we've seen in 40 years. It's important to think about what decisions we're making from an investment standpoint, as it relates to expected real return.
And the reality is, with interest rates where they are today, it's hard to draw a line to a positive real return over the next couple of years in bonds. It's not to say nominal returns couldn't come back to you know, some positive rates. But even with inflation hopefully starting to abate a bit, you're likely going to be accepting a bit of a negative return or maybe breakeven return from a real inflation adjusted standpoint, on the bond side.
On the stock side, that's not necessarily the case, you know, the expected return from a real basis or inflation adjusted return basis is still positive today. That’s one of the key issues as we think about: what are the what are the moves we should make and is rebalancing the right decision with stocks where they are today? Our feeling is it absolutely is because everyone on this call needs a portfolio that's outpacing inflation over the next 5-10 years and beyond. And today, the best way to do that is through a diversified stock portfolio.
Peter Lazaroff: Yeah, obviously, if we could know when the losses were going to stop and know when the gains were to begin again, that would obviously be preferable. But somebody would have won a Nobel Prize by this point if that were possible. And I do think it's important to note that if you look at the returns over the past 20 years, half of the market's best returns happened during a bear market. And another 34% of the best days in the market happened within the first two months of the market bottoming. So you rebalance because you don't know when things are going to turnaround. You rebalance because that's what the financial plan we've built for you says that we're going to do.
And we rebalance with as much diligence in a down market as we do in an up market. And as Chris mentioned, we've been doing a lot of tax loss harvesting for people. Across the firm, we have invested a lot of time and resources in our portfolio management system in the past couple of years, which enhances our enhances our ability to do better, more efficient tax loss harvesting for clients in times like these.
We’re really proud of the team for adopting this new technology that even though maybe it's not obviously apparent to the clients, you know, the day-to-day experience, but what we’re seeing on the back end has been really impressive thus far.
I’m going to let the questions pile up a bit and keep going through some of these charts. I did drop the link to this particular blog post into the chat.
This fourth chart is just a quick look at bear market declines. There's nothing predictive here, per se, I think it's useful for context. You see that the average bear market lasts about a year and it's down 30%. There are bear markets that are not associated with a recession, and those do tend to be a little shorter and a little less deep in their losses.
I think if we're being honest, the Fed is sort of signaling that they're okay causing recession, so maybe we're in line here for a recessionary bear market. I don't say that to cause any panic. Again, I think when you say stay the course, it's important to really acknowledge the facts. And even with interest rate hikes, there's typically about a 12-month lag between interest rate lift off in recession. And I suppose we could go through a lot of reasons on why it seems unlikely we'd have a recession this calendar year, but at the end of the day, if we go back to our financial plans, that financial plan assumes a pretty similar magnitude and frequency of downturns as we've had in the past. So we just never tried to predict when and why a downturn or recession will start, we plan for them
Chris Kerckhoff: But I think it's also worth mentioning, Peter, the calling of a recession is one of the most delayed economic calls in our system with despite all the advances we've made from a technology standpoint and analytic standpoint. Recessions are usually called when the economy is already starting into a recovery mode out of the recession. So that's why we don't get too hung up on are we in a recession yet? Are we headed into one?
The reality is the historical economists will basically tell us where that ended up. But I think what we're much more focused on is what are the investment decisions we need to make now to position our clients to be successful? Over the coming year, three years, five years, 10 years and beyond.
Peter Lazaroff: Yeah, that's a great point. And certainly, if you were to wait for the all-clear signs, you would miss out on quite a bit of return. The markets typically turnaround on less bad news, not necessarily good news. So when the bad news is less bad is when things tend to turn around.
One thing we know is that performance following a down market tends to be pretty good. It's somewhat seemingly inherent when you think about it: your stocks are cheaper when they're lower. And that's what makes returns higher in the future. I'm showing a little historical context in the following one, three and five years here again. This (6th) chart has always been one of my favorites though, the history of bull and bear markets.
The bear markets are here in red. Bull markets are in blue. Our job is to help you capture the markets returns. And if we worry too much about avoiding these little red downturns, we miss out on what is disproportionately larger and longer bull markets.
Earning the market return is not easy. It involves accepting those negative market returns. And obviously, they're not losses unless you're realizing them. I really think this chart does a lot to kind of put in perspective why you'll we're always saying “stay the course and don't worry about the downturns because we are accounting for these in your financial plan.”
Chris had also mentioned the bond market, which has seen some losses, just to give a little visual here of the yield curve. This came from JPMorgan, where you see where the yields were on bonds at the start of the year and where they were as of May 11. When interest rates rise, bond prices fall. And this is a pretty abrupt change in interest rates. You're seeing nearly a percent and a half on the 10 year Treasury.
In the last chart in this blog post, is a visual that explains why long term investors are going to benefit from higher rates. It takes a hypothetical portfolio that has a starting yield of 2% and a duration of three. Now I've chosen this because Plancorp fixed income today is about a duration of three. So there is an intentional choice I've made here. But this is purely hypothetical all for illustrative purposes.
If you look at the gold bars, this is what the return on a 2% bond portfolio with a duration of three would look if interest rates didn't change, you did earn 2% in the first year, you're up 4% in the second year, a little more than 6% in the third year, the reason you're up a little bit more is because you're reinvesting interest in principal.
If interest rates increased by a full percentage point, you see that you lose money in year one. But by year two, it turns positive. In year three, it's still trailing a scenario where interest rates don't rise or where they decrease, but by year four, it's additive to returns. This is the real important piece here. This is the math behind understanding that if your time horizon is greater than your duration, then higher interest rates are going to benefit you.
This is a pretty important concept as you're thinking about your fixed income holdings. We still view fixed income as an area where the primary purpose is to reduce the volatility of the overall portfolio. Your biggest returns are going to be in stocks. Our financial planning models assumes only a 1% return above inflation for bonds over the long run. Again, that's just an average it's not every year. And when you think about recent inflation, the average inflation over the last 10 years, including these big inflation prints we’ve had recently, average inflation is still well below 3% in the past decade. And yet you have really high bond returns.
Bonds have had a great run, so we should expect much lower returns over the next decade or so, but that doesn’t mean they aren't going to provide return. And more importantly, that doesn't mean that they will offset the volatility of your stocks.
We're spending a lot of time on presently at the Investment Committee level looking at the bond allocation, thinking about ways to improve the experience to incorporate some of the latest research, but also to make sure that the clients don't lose faith in the purpose of these bonds. Because at the end of the day, your bonds are there to be less volatile. Yes, they currently have negative returns, but they are not down as much as stocks and that gives you a lot of ammunition for rebalancing
Chris Kerckhoff: I think it's always important for us to acknowledge that we fully understand and recognize this is a difficult time to be an investor. There’s hardly an asset class that has gained in price.
And even cash, is are losing money in cash on a real return basis.
This is the first higher inflationary period many of our clients have lived through, myself included. I’ve been at Plancorp for 25 years and never seen inflation like this.
Where companies are increasing prices and you see that show up on the revenue side. What comes under pressure is the earnings and profit side. And that's where, we're starting to see some of the retailers talking about these higher, whether it's shipping cost, transportation costs, the cost of inventory has gone up, it's hitting their bottom line a bit.
The positive is you should expect over time that companies will continue to find a way to stay profitable, to pass on those the price increases to the end consumer and drive profits back to the levels that investors are demanding. So, if there's a silver lining here, I would say it is that we do have inflationary periods of the past that we can look back and see what's happened. And there are positives, especially for diversified portfolios, where value stocks which tend to do better in inflationary periods.
We’ve generally got an overweight to value stocks in our factor portfolios. And international stocks have also tended to do well during periods of higher U.S. inflation, although inflation is really a global phenomenon right now because of the supply chain issues that all come countries are experiencing, and also because of what's going on from a geopolitical standpoint with the war in Ukraine.
But all in all, we do expect that the diversified portfolio will continue to dampen the volatility. We know nobody enjoys a down market. But as Peter likes to say, that’s why we expect positive rates of return going forward on a long-term basis, because we're living through short term pain and volatility. You get paid to weather the storm.
Peter Lazaroff: Because we know these periods are harder, it’s why we’re trying to communicate with clients in a variety of ways. Obviously, our wealth managers reach out to you all on a regular basis. But we do these calls. Chris has been doing an Alexa update on a monthly basis to talk through some of the big financial headlines. I have a podcast that's been coming out on a weekly basis. We're continuing to try to find different ways to communicate with everybody because one of the things that’s challenging about living through a bear market is that the information you consume is typically not information that has your best interests in mind.
The type of commentary that you're going to hear during a bear market is typically going to be designed to want to grab your attention. The best way to do that is to scare you a little bit. And so I think we're going to continue to try to do sessions like these, as long as there's demand for them.
We have some questions – I didn’t notice them until now, so I apologize to everybody. We will start hitting some of those.
There are two crypto questions. One asks us to talk more about crypto in this market. One asks for just our general thoughts on crypto.
I would say my view has developed from when I first published thoughts in 2017 when I found Bitcoin fascinating but wasn’t sure if it was worth nothing or a ton. Last year I published a piece as interest in Bitcoin and other cryptocurrency was growing. In general, it’s not so much that I’m anti-crypto, but I felt and still feel like a lot of the reasons people are interested in it are faulty. For example, a lot of people call it a currency, but it definitively is not. A currency doesn’t require you to pay capital gains to buy a pizza. Nor is it a store of value. It is way to volatile for that distinction.
But the one thing about any asset, whether it's buying an individual stock or a digital coin, or a sector ETF is that there is nothing in our financial planning models that requires that you get invested in an asset that just goes completely bonkers in order to make your finances work.
We've spent a decent amount of time talking about cryptocurrency at the Investment Committee level, but there's really never been any sort of traction on a willingness to proactively add it. I think, as an asset class, it doesn't have enough data for us to make any sort of reasonable assumptions from a capital allocation model perspective.
Chris Kerckhoff: The couple of things I would just add to what Peter's saying first, I think it's always really, really important when you talk about crypto and digital assets to you have to separate out the technology the underpinning technology of blockchain, which is hugely transformative and important, from the digital currencies themselves. I make that distinction because it's hard to necessarily know where this ends up.
There’s been some really interesting experiments that have happened recently that have not ended well. El Salvador recently, I guess it was last year, adopted Bitcoin as a currency of record for the country. And, you know, we're just about 12 months into that experiment, give or take. And to date 5% of all transactions across the country are happening in Bitcoin. So it's, it hasn't been successful, by any measurable economic output. Many retailers don't accept it there. And part of that is because transaction costs are exceptionally high in cryptocurrencies across the board, you know, you see transaction costs 7% or higher, which doesn't sound like it's really a great currency play, in terms of the ability to spend those assets. We also have seen problems for stable coins, which were designed to stay pegged to the dollar, and one of these recently is now down close to 80%. All the crypto fans have talked about Bitcoin and Ethereum would really shine when inflation spiked and it's really kind of been the exact opposite.
I'll just close with one other thought…a few years ago, I had the opportunity to sit in and listen to one of the committee members for the Fed’s digital currency subcommittee. The Fed and China have been looking at their own Fiat digital currency for several years. China has launched theirs and think it's reasonable to think that the US could go in that direction. They want to take a measured approach and deal with thoughtfulness. But I think that'll really be kind of an interesting data point. If the world reserve currency adopts a sovereign backed digital currency on the blockchain, I think it's going to be really challenging for many of these other players to hold up in value. So cryptocurrency is something you can hopefully tell we're spending time on, but it's hard to come up with a risk return analysis that says there's an expected positive rate of return that we believe is worth investors taking the risk, and the volatility we see in that marketplace.
Peter Lazaroff: So there is there are two other questions here. One is if you have cash on the sidelines, when is the right time to invest it?
The math would say the sooner the better. You know, your return is always highest when you give yourself the most time in the market. But it can be easier to dollar cost average into the market from an emotional standpoint.
Chris Kerckhoff: I agree. I think there's a lot of behavioral research that says you're better off automating according to some monthly or quarterly schedule, just putting some in on a systematic basis because your emotions get in the way.
Back to Peter's earlier point, bear markets is some of the largest upticks happened in the stock market and then they also happen in the midst of the tide turning from a bear market to a bull market. Missing out on those days is significantly damaging to long-term rates of return. Unfortunately, we just we don't know when those days are going to happen.
So it really gets back to if this is long-term money. It’s important to have some kind of cash reserve, but cash on the sidelines above and beyond that ought to be invested in a long-term strategy. Investing it all at once is always going to have the higher expected rate of return, but emotionally that’s more difficult. So we often coach people to do it in a phased approach either monthly, quarterly, or twice a year.
Peter Lazaroff: The last question we have here is regarding tax loss harvesting. It's just a request for more details on the steps that we take for tax loss harvesting.
So the Portfolio Management team look at the portfolios on a daily basis. The thresholds that we use for when to harvest a loss is 5% and at least $5,000 in size. We have a fully centralized trading platform where the wealth managers enter very detailed notes to the portfolio management team every time they meet or speak with you. Before just doing a trade blindly, the Portfolio Management team looks for relevant notes such as are there upcoming cash flow needs? Are there considerations for taxes? Is money about to be deposited such that this trade would not make sense.
This centralized process allows the wealth managers to spend more time focusing on you and less time focusing on the trading itself. I guess I veered a little off of the tax loss harvesting there. But Chris, anything to add?
Chris Kerckhoff: No, I think I think you've covered it. One thing I always note to clients, especially long term clients, is sometimes you’ve been invested for a long time and there are no losses to harvest in this type of decline. So for some people, even though there are losses year to date, that doesn’t necessarily mean there are tax losses we can capture. I know most people know that, but it just bears mentioning because we have some very long-term clients that won’t actually get the opportunity to tax loss harvest because their cost basis is so low.
Peter Lazaroff: Alright, that looks like we’ve covered all the questions. Chris I will let you close this out for us.
Chris Kerckhoff: First of all, I just want to thank everybody for taking the time to be on the call. If there's a question that come up or something we didn't cover, please don't be shy and reach out to your wealth manager or send me an email or Peter an email.
We definitely want to address concerns that people have. And as I said, before, we fully acknowledge and understand that people have concerns these days. The financial press and the mainstream media doesn't do anyone any favors when markets are in rougher waters, like we are right now. They're really focused on driving fear and concern. And at the end of the day, the traditional Wall Street model is predicated on driving revenue and profits by having people trade and transact. So the number one objective there is for you to do something, right
And sometimes in life, but certainly in investing, the best decision we make is to not make that big decision, especially in periods where we're doing it out of a place of fear concern. We spend a lot of time with clients talking about your long term goals and near term goals and making sure that we've got a strategy put in place and designed your portfolio to meet those objectives, whether they're in the short term or long term. And we do that with an eye towards the idea that markets are going to go through periods like this. So hopefully we've conveyed that periods like this are not something that drives a lot of concern on our end.
We certainly always pay close attention to the markets. Please know we are laser focused on doing everything we can exploring all opportunities. We probably don’t talk about this enough, but we do meet with all sorts of investment providers through the course of the years, and most of whom we don't end up using in our client portfolios. But we know our job as fiduciaries is to look high and low for the best investment options for our clients. And so we're certainly actively doing that. And we'll keep you posted if anything changes.