Mid-year Market Recap

Jim Lowell:

Hello, this is Jim Lowell and I’m the chief investment officer at Adviser Investments. And I’m here with The Adviser You Can Talk To Podcast. I’m joined today by Dan Wiener, chairman of Adviser Investments. And we’re inviting you to join us as we look back at the first half of this year and ahead to the second half, what potential risks and returns are in store for investors like us. Dan and I will discuss reopening and recovery investment themes, touch on live-wire topics like higher taxes and lower-yielding income. And of course it doesn’t go without saying or being thoughtful about how on March 11, 2020, the pandemic was declared and its scope was a widening gyre whose reality and fear encompassed the globe. Today, despite the reality of the rates of vaccinations beginning to slow and new variants emerging, pursuit of gains rather than avoidance of risks appears to be the main driver of market momentum.

Jim Lowell:

In fact, we think investors have become too complacent about risk, and we will start with this in our conversation today. We’ll also delve into it in our forthcoming quarterly investment outlook. And again, discuss it in our upcoming webinar, which is on July 28. And of course we hope you’ll join us then.

Dan Wiener:

That’s a lot of risk, Jim. We’re going to be talking about risk a lot.

Jim Lowell:

Well, then we go back more than a couple of decades in this business, and we know that being able to manage risk wisely and well is the safest route to reliable long-term returns. And why don’t we just jump in and talk about the risks that we do see currently and how they may potentially impact the second half of the year? And of course, what opportunities we see as well.

Dan Wiener:

Yeah. I’m thinking about what you just said about our long history and the fact that managing risk is essential to long-term returns. And investors really haven’t had to deal with a lot of risks lately and we almost feel old-fashioned sometimes talking about risk because there are so many moonshots, so many stocks that are just seem to be one way tickets to wealth, but I’ll go into a couple of risks. We’ll talk about the market a little bit. I think the risk everybody’s talking about right now is inflation, right? We got a report earlier this week that the headline inflation number, the one that you always see in the newspapers was up 5.4% year over year, which was even higher than the 5% number we got in May.

Dan Wiener:

The word you’re hearing a lot is “transitory.” Meaning that a lot of the items that drove inflation higher are not things that are going to stick around. I mean, car rentals, used cars. We know about the chip shortages that are causing problems on the sales lots. We know that folks are coming out of lockdown. They want to go back to work, but they don’t want to take public transit. So they’re trying to buy another car. Used cars are up, the rental car companies don’t have any inventory, they need cars, but this is again, it’s transitory, right? And I think people have to realize that while there is a risk that inflation will be higher than we think it will be. A year ago, inflation was 0.6%. Now we’re talking about 5.4%. The rise in inflation mirrors the decline in inflation and the decline in all sorts of economic activity that we saw during the pandemic.

Dan Wiener:

So I think what’s really important for people to know when they’re reading about, listening to people pontificate like us about inflation, is I’ve heard a lot of commentators say we’re heading into a period of persistently higher inflation. That seems to be the buzzword, persistently higher. You have to look back and realize that inflation has been low for a long, long time. Over the last decade, inflation ran about 1.7%, 1.8%. Not even at the 2% level that the Fed feels is the appropriate level. In the 1980s, the average inflation rate was 5%. So I think we can see persistently higher inflation down the road, but I don’t see that that’s a problem. It’s a question of how persistently higher. And I don’t think that these 5% numbers we’re seeing today are numbers that we’re going to see in a few more months.

Jim Lowell:

I completely agree with that, Dan, we talk about it almost incessantly with the investment research team every Monday, review it every Thursday with everyone in the firm, because we know that inflation is a hot-button headline. But if you look to the bond market, if you look to the gold market (the two most sensitive to inflation, especially rampant inflation), they’re simply not buying what the headlines are suggesting we ought to fear. It doesn’t mean it’s as you correctly pointed out that we don’t pay attention to it. We don’t dig into the details. We don’t understand the history of it. And clearly we do understand that even marginally higher rates of inflation in a low yielding environment can be quite punishing for income investors, but all that said and done, we continue to believe it will be transitory. And we also understand that the Fed, and the Fed equivalents, around the globe are not unaware of either the headlines or the material facts of this bad of inflation.

Jim Lowell:

And of course they like we expected to see inflation if vaccination success took hold. If reopening success began to manifest itself on scale, it is actually a sign of returning to health, not a sign of distress.

Dan Wiener:

You mentioned both bonds and gold. So when this big headline CPI number came out on Tuesday, the bond market took it very calmly. They didn’t move much at all. And then later in the day, when there was an auction of 30 year bonds, all of a sudden the yields ticked up. The gold market, gold peaked a year ago in August of 2020 at over $2,000 an ounce, today it’s around I believe $1,800 an ounce. So if inflation was a big issue, how come gold was higher a year ago than it is today? And then the big inflation symbol of the day is lumber, right? Lumber, the housing market was hurting because there was the cost of lumber was so high, folks were worried that they were adding $30, $40, $50,000 to the cost of a new home. Lumber today is at $650 per 1,000 board feet. It’s down 60% from the peak. It hit two months ago. It is almost where it was three years ago. So, and that was a peak then. So, again, I think the word transitory does really count for something here.

Jim Lowell:

I would agree.

Dan Wiener:

The other big risk I said we’d talk about is stocks, right?

Jim Lowell:

Yup.

Dan Wiener:

The stock market has been performing terrifically. People have made a lot of money in the stock market. I think the risk is always present, but by itself, that risk is not a bad thing. What people have to realize is that on average, and it doesn’t happen every year and sometimes it’s worse, sometimes it’s better, but on average, we experience a 14% entry year decline in stocks. If you look at it the S&P, I mean, we’ve hit 39 new highs on the S&P so far this year, we haven’t seen one 5% drop. We have just not experienced the kind of volatility that we typically do. And my biggest fear in terms of the risk of the stock market is not that the stocks go down because I think stocks you and I have been around this block so many times, a declining stock market is just something that is part and parcel of playing in this game.

Dan Wiener:

But what worries me is that investors or traders get spooked, which could exacerbate any decline because people have become complacent about the risk of stocks. What do you think I missed on the risk side? Because boy, I’ve been talking about a lot of them.

Jim Lowell:

I’ll go through my risk checklist very quickly, but I think just to sum up your macro point is really on complacency is that the main risk is that there’s a growing belief, that there are no risks. And so even a slight and natural correction in the stock market, which we have not seen so far this year, could unnerve on investors in the very short run, won’t unnerve us. Certainly won’t unnerve the managers we invest in. In fact, if this market wants to give us discounted prices of the best ideas, please let it do so.

Dan Wiener:

Jim, you taken any money out of the market?

Jim Lowell:

Absolutely not. I may have to if some home renovations go on and lumber prices don’t continue to go down, but other than that, nope. There are people who love to make a living claiming that the market is a house of cards, but those are card sharks. We’re investors disciplined, battle-tested over decades of some truly trying times. In terms of my risk checklist, beyond what we were just talking about. We talked at the event with the investment research team led by Jeff DeMaso about the COVID variant, potentially proving to be more disruptive than currently priced in. That’s a risk that we faced the second half of the year. Any unexpected event that materially changes our view of the recovery space, reopening space, the scale of it—we were just recently reminded from the assassination in Haiti, we’re always cognizant of the fact that a political or geopolitical event of some market magnitude here or elsewhere—could impact not just our market, but the global markets. We’re entering hurricane season. We’ve already had just spectacularly wild and dangerous weather here, elsewhere. So natural disasters are a near term risk.

Jim Lowell:

Dan mentioned the valuation concerns in the marketplace, the complacency concerns in the marketplace. And while we do think that there are some stocks that are absolutely in bubble territory, even inside the technology sector, we think that our superior manager selection can help lead to some good long-term gains there. What else do I have on my risk checklist? Let’s see.

Dan Wiener:

I’m going to hit you on this earnings thing for a minute because stocks are highly valued at the moment, but what they’re really looking toward is strong earnings coming out. And we’re just starting to see the first earnings reports for the second quarter and they look good. So I think that stock prices have, as they always do, they look ahead and it appears that companies are meeting matching some of the expectations that traders had in terms of where they’re going to come through with earnings. But again we’re going to see this big bounce in earnings, and we can’t expect for these earnings growth rates to continue.

Jim Lowell:

I wish we could but we cannot. But to your point, Dan, as fundamental investors we look at earnings, we understand that earnings ultimately drive the market. We look at interest rates. We’ve already talked about how they correlate with inflation. We also look at economic data. In terms of earnings, one other positive at this particular midway point of this year is that the guidance from the companies is becoming a little bit more believable. A year ago, we didn’t even have a vaccine, let alone vaccination success, let alone reopening, let alone reopening success. Now we do. Now the guidance is becoming a little bit more material in terms of what people, how CEOs, how CFOs are telling us things look and how they expect them to look in the intermediate term.

Dan Wiener:

Right. That’s the most important thing is whether they have, Wall Street likes to call it visibility, whether they have visibility into their businesses and where their businesses are headed in the next six months, one year, three year, five years.

Jim Lowell:

Yeah. And that’s becoming a little bit more believable, which is a good thing, and I’m not going to belabor my risk checklist because I want to get to opportunities. But I do want to mention a risk opportunity that has macro implications for the market, literally on any given day, I think, but certainly we’ll have something to say about how the domestic and global markets behave for the second half of 2021. And that’s China.

China is celebrating its new 100-year plan after, according to the politburo in China, having achieved all the goals of its prior 100-year plan. And China is clearly reemerging. And we’ve talked about this time and again, and we will revisit this theme time and time again because China next to our economy is the world’s largest economy. Next to our military power is effectively the next largest military power.

Jim Lowell:

China is reemerging as an imperative economic powerhouse while at the same time, accelerating their reversion to less free market, less freewill, less freedom for their own citizens. And we’re seeing a more entrenched communistic control of citizenry in private companies. And that is going to rattle individual companies, Chinese companies, companies that cater to Chinese manufactured service sectors for some time to come. And as I say on any given day, China can really rattle the market based on what the politicians are doing to their own market, as opposed to what the company leaders inside of China hope to be able to achieve for their companies.

Dan Wiener:

I recently read a book. It was fiction, but it was written by a former admiral in the U.S. Navy who basically forecasts not very far in the future, a China that is militarily and economically stronger than the U.S. draws the U.S. into a global conflict and ultimately comes out on top. And at times it felt like this book had almost been drawn from the headlines. It felt almost too real. So I guess the question is do you just stop buying China? Do you avoid China in your portfolio? I know short term we’ve got people like Cathie Wood over in ARKK who’s been selling off some of her China holdings, but of course she’s not the best bellwether except for what’s in the headlines yesterday. But do you just avoid China and that enormous economy?

Jim Lowell:

We don’t, and we don’t think it would be wise to at least not at this juncture. The politburo in China changes not daily, but certainly year over year, there are different manifestations of the ways in which they view a free market, their particular market’s approach towards the global free market. Sometimes it’s more accommodative. Sometimes it’s more restrictive. Right now, it’s in a more restrictive phase, although it’s hyper-focused on some big technology companies inside of China. China’s politburo fears the freedom that capital can bring, and I don’t think that’s going to change, but I do know that as the world’s second-largest economy, as a place where their middle class population dwarfs the total population of our country for that matter, India’s either equal or slightly middle-class is numbers are equal or almost as large as our population.

Jim Lowell:

It’s an economy that companies can certainly profit from by catering to, and we know that the Chinese consumer, especially under the strictures of the social ranking system in China, which views every purchase through the lens of behavioral control and has ramifications about where you can travel, who you can travel with, when you can travel, where you can go to school, where you can get health care. Your purchasing behavior in China is their window into your world, your belief system. We know with that level of restrictiveness, many Chinese consumers are not going to buy “brand America.” They’re going to buy brand China because that’s the way they can signal to the social ranking system that their heart lies with China. So Chinese companies will absolutely, we think longer term be able to profit more based on just that draconian trend alone.

Jim Lowell:

In terms of looking at China’s quest for world domination. I mean, you’re talking about a 5,000-year plan, not a 100-year plan, and it has gone in cycles. And this is a cycle that will be very challenging, not just for those that compete against China, but we also think for China itself, and we understand too, that even inside the politburo, there’s this dawning recognition for the first time in terms of actually expressing it, that taking care of the environment is going to matter more to their economic health than it has done ever before. So maybe China’s size will actually encourage it to behave better with regard to the environment, better with regard to its citizenry. But we’re not political scientists, we’re investors. We think there will be opportunities. As we know we’re expert managers of active managers, and we feel very confident in the managers in the international and China region space that currently are represented in your portfolios. We’re very confident in their ability to be better informed, analyze their information better and better execute relative to the broader market.

Dan Wiener:

We would do our clients a disservice if we didn’t talk a little bit about the bond market. We’ve been focused on stocks, we’ve been focused on China. We talked a little bit about inflation, of course, but yields remain incredibly low.

Jim Lowell:

Oh, yield’s dead.

Dan Wiener:

Yeah. Well, it’s funny with all the worry about inflation I think what people are missing is the fact that a little inflation could drive yields higher and bond investors would not be displeased by higher yields, nor would those who’ve got money in cash, because right now cash pays nothing. By the way, I’ve been seeing a lot of articles about alternatives to cash, like ultra-short bonds. We’ve talked about it before. I-bonds, which of course you’re limited to buying $10,000 worth a year, if you do the math, the differences are really de minimus. I mean, they might buy you dinner at McDonald’s for four. It’s a lot of jumping around to try to earn a higher yield on your cash and then may be worth it for most investors.

Jim Lowell:

I would agree with that, Dan, but to get back to your, you used the word yield. What’s the difference between yield and income?

Dan Wiener:

Yeah. Well, I mean, exactly. Yield is typically when people talk about interest being paid on a bond, but you can also have a dividend yield, right? The dividend that’s paid off of a stock, but as I like to say again, and again, and again, you don’t buy goods and services with yield, you buy it with cash or credit card. And when you go to the supermarket, they’re not asking whether you’re paying with interest, dividends or something else or capital gains, they’re asking is it cash or credit. And I think that it’s very important for investors to realize that there are many ways to generate “yield” in their portfolios. We take a total return approach. And I think that’s the smart way to think about it. Not necessarily, I can only live off whatever interest my bonds are paying me, or I can only live off whatever in dividends my stocks are paying me.

Jim Lowell:

Yeah. I think that’s an excellent point. I would also, I know we’re almost out of time, but I would also just underscore the fact that our individual bond manager and bond expert of three decades plus, Chris Keefe always likes to say that the yield is always highest before there are no yields. By which he means don’t chase higher yielding instruments because the highest yielding instruments are often the poorest credit quality, the most vulnerable to not actually providing you the safety and security that you’re seeking.

Dan Wiener:

Well, we’re seeing that right now in the junk market, right? And the high-yield market, that gap between government bond yields and junk yields, which is called the spread, it’s incredibly narrow, which means investors have been paying up. They’ve been paying a lot for the extra yield that they’re getting off these junk bonds. Of course, that can be something of a scary prospect. Inflation bonds are really, really expensive too. The yields are deeply negative. Interestingly, and I know you keep a very close eye on Fidelity, I keep a close eye on Vanguard. Vanguard recently said that they believe that periods like this are made for active management, that in the bond market, that active managers can jump on opportunities that the indexes, the passive indexes simply can’t. I thought that was kind of fascinating.

Jim Lowell:

It is fascinating. It certainly correlates with our longstanding belief in pursuing excellent active managers. And of course the investment research team spends their full time in that pursuit and making sure that the managers that we’re currently invested in alongside of you are in fact still at the top of their game. I mean, we, inside of our portfolios, we are fortunate as investors to have represented quite literally some of the best minds in the business.

Dan Wiener:

Okay, very quickly, meme stocks or blue chips, which one do you go for?

Jim Lowell:

It’s not even a wrestling match for me, Dan. Blue chips are going to be able to help you build your wealth. Meme stocks might help you build your reputation at the local barstool, but a barstool is not an investment plan.

Dan Wiener:

I believe a couple of guys on our team going to be talking about meme stocks in an upcoming podcast, so…

Jim Lowell:

That is absolutely correct.

Dan Wiener:

I’m looking forward to hearing that one.

Jim Lowell:

So you toss me that one, I’ll give you this one. Value versus growth.

Dan Wiener:

Oh man, you’re always throwing the value growth thing at me because I have so much fun with this. First of all, I don’t believe that one should invest in value versus growth or growth versus value. I think what you look for is great managers who ultimately pay value prices for growing earnings. So call me a heretic, but I just I’m sticking with that. We’ve been in a market recently that where growth had been leading for years and years leading up to about fourth quarter of 2020. And then all of a sudden there was this turn in the fourth quarter to value, value led for about eight months. But in the last couple of months, guess what, we’ve gone backwards. The value trade kind of coincided with the reopening of the economy, but now the economy is essentially reopened, whatever value the value managers found in the value stocks has probably been recognized. I’m back in the growth camp, but I still want to buy growth at a value price.

Jim Lowell:

We like to invest in growth managers that know how to find good values. And we do like to see value managers who know how to find hidden growth opportunities. On that note, Dan, I think I will take us out.

Dan Wiener:

Take us out, take us out.

Jim Lowell:

It’s been a great conversation. In some overall, we continue to think that vaccination and reopening success will remain the most important criteria and determinant for economic and market growth in the second half of 2021. Fundamentals which we talked on earnings, interest rate, economic data matter, but they might be overlooked in moments of fear and greed. And we’re very mindful of this, framing our analytical assessments of economic and earnings data based on what we know, not what others fear or would have us hope for. We continue to think the Fed is doing the right job in terms of safeguarding our economy.

Jim Lowell:

We’re not out of the woods. We’re not even out of the flu woods yet. In fact, we’ll be reentering them in September, October. So there will be challenges ahead known and unknown, but Dan and I have been in this business of securing your financial future for decades. Inside of those decades, we have seen exceptionally challenging times as well as times where the wind has been at our back. We think both are likely to occur as we expect volatility to increase from its ultra-low levels in the second half of this year.

Jim Lowell:

And of course we’re right by your side every step of the way. And speaking of the way, one way in which we are always not just on your side, but by your side is with these regular Adviser You Can Talk To podcast. So with that, this has been Jim Lowell.

Dan Wiener:

And Dan Wiener.

Jim Lowell:

From Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show and you can check us out at adviserinvestments.com/podcasts. Your feedback is always welcome. If you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com. And thank you for listening.