Are We Headed For “Yield Curve Control”?

By now you’re probably thinking what is “yield-curve-control” and why should I care? Yield-curve-control is a term that is widely used among macro-economists and students of interest-rate policy but not among the rest of us. In this article, we’ll discuss what it is, why it may be deployed and how it may impact the investments in your portfolio.

So, first off, what is yield-curve-control?  Yield-curve-control refers to a seldom-used strategy by central banks to control interest rates. More specifically, central banks will purchase an unlimited amount of government bonds to support prices. The goal is to create a price “floor” in the government bond market and, consequently, an interest rate “cap.” It is important to differentiate yield-curve-control from quantitative easing. With quantitative easing, the goal of bond purchasing is simply to increase liquidity in the marketplace whereas yield-curve-control has a specific interest-rate target in mind (e.g., a central bank may want to “peg” its 10-year bonds at a rate of 2%).

 Now for the key question, why would a central bank want to peg interest rates? If you ask the U.S. Federal Reserve Bank, the answer is that yield-curve-control is simply another tool in the toolbox to achieve its “dual mandate” of (1) price stability and (2) full employment. Obviously, yield-curve-control is not helping price stability so it’s really the economic prosperity/full employment objective that they’re arguably targeting. In this sense, yield-curve-control enhances business activity because it makes capital cheaper than it otherwise wants to be. Corporations become more inclined to borrow, make investments and hire employees while consumers become more capable of making large purchases on credit (e.g., homes). If you artificially lower rates, you’re providing a tailwind to the economy.   

For the more skeptical economists, yield-curve-control is deployed primarily as a tactic to control borrowing costs for governments during periods of substantial borrowing by them. In other words, nations can borrow more when interest rates are lower because borrowing costs are not consuming a substantial portion of their annual budgets. So, critics contend that governments are manipulating the bond market simply to keep their costs under control during periods of excessive borrowing. If ever there was a need for the U.S. government to deploy yield-curve-control it is now. The Great Recession and now COVID have resulted in substantial government debt. As shown in the chart below, U.S. debt has climbed to over 100% of U.S. Gross Domestic Product (“GDP”) – a level not seen since World War II. 

Source: Federal Reserve Economic Data

So, would central banks really manipulate the bond market in this way? Many would be surprised to learn that several countries, including Australia and Japan, have been actively deploying yield-curve-control in recent years. For example, in 2016 Japan’s central bank made a commitment to target a near-zero interest rate on its 10-year government bonds. Notably, this program has been successful and other central banks are taking notice. For example, data from Japan suggests that the use of capital for yield-curve-control has proven to be more efficient than prior efforts of quantitative easing (i.e., it has a greater effect per dollar deployed). 

Perhaps you would be even more surprised to learn that yield-curve-control was actively deployed in the United States from 1942-1951. This is a particularly scary comparison to today because it demonstrates that to reduce its debt a government has an alternative to paying it down – it can use inflation to shrink it. That’s right, from 1942-1951 the United States shrunk its debt as a percentage of GDP not by paying it down but by letting the rate of inflation run well above their interest rate costs. This situation left them with a much more manageable debt load as a percentage of GDP at the end of the period. This realization has led to the expression that “inflation is not a bug but a feature” of federal policy in times of great debt. In other words, governments aren’t necessarily trying to control inflation during times of excessive debt, rather, they’re using it to their advantage. The downside of this tactic is that inflation acts as a tax on consumers as it reduces purchasing power over time – a phenomenon that, unfortunately, is most detrimental to the lowest income earners and retirees living on a fixed income.

Whether it is achieved by yield-curve-control or market forces, our bet is that interest rates will remain relatively low for the foreseeable future. Even though the Federal Reserve Bank has telegraphed rising interest rates in 2022, it seems inconceivable that we’ll return to the rate environment of the early 2000s where a 5% yield on a bank certificate-of-deposit was commonplace. Neither the U.S. government nor U.S. corporations could likely afford to return to that type of rate environment anytime soon. 

Given the likelihood of interest rates remaining at relatively low levels, investing becomes more challenging. Both government and corporate bonds may prove less beneficial in the coming years as yields struggle to keep up with inflation – thereby leading to negative “real” yields (i.e., yields net of inflation). Stock market impacts are more difficult to ascertain as artificially low yields are a tailwind to corporations, however, rising inflation generally leads to rising employment costs and shrinking margins. This type of environment tends to be beneficial for “real” assets. Investments such as real-estate, land, precious metals, collectibles and various commodities are often top performers in this environment as investors rush to hedge the effects of inflation and protect purchasing power. Unfortunately, a simple broad-based buy-and-hold stock/bond portfolio may be the worst possible strategy. In our opinion, it may prove most beneficial to deploy a tactical approach to stocks with targeted sector exposures, a dynamic approach to bonds where duration is adjusted throughout the period of rising rates and a healthy allocation to non-traditional pro-inflation assets. We recommend discussing your portfolio’s risk level and diversification with a trusted financial professional.

The Return of Value Investing?

It’s been a long tough road for “value” investors. As we all know by now, the last decade has been very good for risk assets of all stripes. We’ve seen valuations soar in high-risk investment categories like private equity and venture capital. Meanwhile, risk-appetite was equally robust in the public markets as initial public offerings flourished and the technology sector surged. While “growth” was in high demand, “value” investments saw diminished interest. In fact, as shown in the chart below, the recent surge in “growth” has led to one of the largest gaps in outperformance that we’ve ever seen.

Source: Isabet.net

So, where do we go from here? To determine where we may be headed requires us to first understand how we got to this point. We would argue that the dominance of “growth” over the last decade was primarily the result of government intervention. Central banks around the world have been very accommodative to markets after the “Great Recession.” Most notably, we have never seen such an extended period of low interest rates. As the chart below shows, we spent the better part of last decade with the Federal Funds Rate at, or near, zero.

Source: Federal Reserve Economic Data

An interest-rate policy like this has profound impacts on risk assets. For example, large public companies were able to raise money through bond offerings at rock-bottom prices - a situation that greatly benefits firms with good growth prospects. Moreover, low rates mean that future cash flows from “growth” companies are not discounted as much by investors thereby causing them to look more attractive. Of course, interest rates only tell part of the story. It’s clear in hindsight that the injections of liquidity (i.e., the bond buying programs) by central banks and fiscal stimulus by governments encouraged risk taking. It’s also noteworthy that federal bank balance sheet expansion in recent years has been without precedent. For example, as seen in the chart below, the US Federal Reserve Bank increased its balance sheet from around $2 trillion at the start of 2009 to nearly $9 trillion today - a whopping 4.5X increase with half coming in the last 2 years. While it’s clear that “easy money” policies are supportive of all public companies, “growth” categories have more gain under these conditions.

Source: Federal Reserve Economic Data

2022 is shaping up to be an interesting year in the growth/value battle. We ended 2021 with some of the highest inflation prints that we’ve seen in decades. With inflation coming in well above the “target” rate of 2%, federal banks no longer have the luxury of being accommodative. More specifically, there is now immense pressure on them to use their tools to rein in inflation. In theory, this means (1) higher interest rates, (2) the termination of bond buying programs and (3) balance sheet shrinkage.  With these potential headwinds for growth, the future is looking brighter for value. Value stocks, which tend to have more stable cash flows, higher dividends and less price sensitivity are primed for a potential comeback.

As we head into 2022 and begin to look at specific sectors, a few categories jump out as being particularly well positioned. For one, the Energy Sector has been out of favor for years following a global “green energy” agenda. However, the transition is predicted to take time, and, following many years of under-investment by the sector, some industry experts expect prolonged high prices and high profits for the sector. Additionally, the Financial Sector may be poised for profit growth. For one, inflation tends to lead to a “steepening” of the yield-curve which improves bank profitability. Moreover, many banks are finding that they over-accrued loan loss reserves in 2020-2021 and are seeing better charge-off results than expected. While it’s impossible to predict exact outcomes, given expected Federal Reserve actions, “value” investors may finally have something to cheer about in 2022.

2021 4th Quarter Update

Top Headline for Q4: The Market Bulls Win!

After a rise in risk sentiment to close the 3rd quarter, one was left to wonder if we had seen the stock market peak for the year; however, the Bulls were not finished. After a strong rally in October, the US equity market had fully recaptured its drawdown and again achieved new all-time highs. In general, equity markets around the globe enjoyed positive returns for the year. The Vanguard Total World Stock ETF (Ticker: VT), which is a blended portfolio of equities spanning domestic and international markets, ended 2021 +18.3%. After some late November and early December volatility, the market saw its biggest 4-day surge of the year before stabilizing to close the year within 1% of another all-time high. In fact, the S&P 500 Index closed at all-time highs on over 25% of all trading days in 2021. This marks the highest total recorded since 1995. Client accounts saw an increased level of rebalancing during the quarter as we rebalance “opportunistically,” instead of specific times during the year (monthly, quarterly, etc.).

What’s quite remarkable about the recent performance is that the macro-level news has not been favorable. For example, in Q4, thanks to the Omicron variant, we endured a resurgence of COVID; the Federal Reserve announced an acceleration of the tapering of their bond buying program; and inflation figures soared, which suggests rates hikes are almost a certainty in 2022. US equity investors shrugged off all of the news and appeared fearless to close the year. And, why not be fearless? The indices spent most of the year hovering at/near all-time highs; the market did not see a drawdown greater than 5% in 2021; and the Federal Reserve, despite the “taper” talk and change of pace, is still “easing” by buying billions in bonds monthly. Yet, as we enter 2022, we’re reminded of Buffett’s famous quote, “Be fearful when others are greedy and be greedy when others are fearful.”  As we will later discuss, some caution is warranted as we enter into 2022.

General Market Update

US Equities:  The S&P 500 Index surged in the quarter finishing up a whopping 10.6% for Q4 and nearly 27% for the year. The Nasdaq Composite was up 8.3% in the quarter (21.4% for the year), and the Russell 2000 Index climbed 1.9% in the quarter (13.7% for the year). The US equity market performance has been nothing short of stunning. In recent years, the US indices have crushed other major developed market indices. It is noteworthy that some weakness is finally emerging in pockets of the market. Specifically, some of the high-flying performers from recent years (e.g., recent IPOs and “profitless tech”) are down from 2021 peaks and are trending poorly. Moreover, the US market has been led higher by a minority of mega-cap positions. As you may recall in a previous quarterly commentary, we highlighted the fact that about 27% of the S&P 500 Index is comprised of seven mega-cap companies (Apple, Microsoft, Amazon, Tesla, Alphabet, NVIDIA and Meta).   

International and Emerging Market Equities:  The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 2.8% in Q4. SCHF finished up 11.4% for the year - an obvious divergence from major US indices. This divergence can be traced to the growth/tech bias of the US indices (i.e., the segments that have most benefited from “easy money” federal bank policies). The Schwab Emerging Markets ETF fell 0.7% for both the quarter and year. Emerging market equities continue to be hurt by weakness in China. Looking ahead, we believe this recent underperformance presents an intriguing opportunity.    

Fixed Income and Credit: Like Q3, the 4th quarter was a quiet one for the bond market. Both short and long bonds were generally flat for the quarter. With most of the damage being done in the 2nd quarter, 2021 proved to be a rough year for the bond market. It’s hard to see 2022 being much better as the set-up for bonds (i.e., Federal Reserve tapering, planned rate increases and inflation concerns) are big headwinds moving into 2022. We continue to view most segments of the bond market as a buffer for volatility in more conservatively allocated portfolios.

Commodities, Precious Metals, Inflation: Some of the COVID driven inflation is proving transitory, but the general trend in commodity prices in 2021 is up with particular strength in industrial metals related to the “green revolution” (e.g., copper and nickel). Precious metals have been range-bound for much of the year despite favorable conditions (e.g., substantially negative real interest rates). All eyes will be on these sectors in 2022 as price changes will have substantial policy implications.     

A Look Ahead

2022 is shaping up to be a very interesting year. The US equity and bond markets are going to be facing headwinds that they haven’t seen in a long time. Specifically, the Federal Reserve’s bond buying program is expected to terminate in Q2. Moreover, interest rate hikes are expected following the tapering of the bond buying program. In general, rising rates are not favorable to the equity market because it raises the cost of capital and causes renewed interest in credit investments. Despite the bond buying taper and expected interest rate increases, both being well telegraphed by the Fed, it would not be surprising to see the market temporarily react unfavorably. An increase in volatility from 2021 is almost a certainty given the unpredictable impacts from what is coming and the above-average current equity market valuation levels. Historically, Value segments of the market tend to outperform during rising interest rate environments. While client portfolios are always well diversified across asset classes, they enter the year with a slight “lean” into Value over Growth. And, as clients know, we like to also express sector market views through our “tactical overlay” to portfolio management. This tactical overlay has a Value overweight through sectors such as Materials, Industrials, Energy and Financials.

To further add to a potentially volatile cocktail, political pressure is intensifying ahead of the 2022 midterm elections. Inflation is soaring and consumers are angry. Anti-corporate sentiment is rising in conjunction with concerns over wealth concentration. Elected officials are pointing fingers and demanding changes which may accelerate any Federal Reserve Bank rate increases. The Fed is supposed to be “independent” of these types of pressures, but it feels less so these days than in the past.

While the year-over-year changes in inflation are certain to fall from current levels, above-average inflation gains continue to feel like a good medium to long-term bet. One of the most unexpected by-products of COVID is that soaring equity markets and bleak working conditions pushed millions of older workers into early retirement. This post-COVID shift left a massive shortfall in the labor force and contributed to the start of wage inflation. Moreover, there are other, more secular, pro-inflation trends including an extremely low level of investment by traditional energy producers and commodity producers in recent years. The government has some control here through the money supply, bank liquidity and interest rates. However, given potential adverse market impacts, will the government use these tools and to what degree? On a more positive note, the widely-covered supply-chain issues that are wreaking havoc on key industries, such as car manufacturing, are likely to see improvement in 2022.   

In summary, it’s a very difficult environment for forecasting. We now have conflicting agendas (i.e., what is good for solving issues like inflation and wealth concentration is not generally good for the equity and bond markets). We see volatility in our future as agendas compete for support. It’s been a long time since we’ve seen a substantive drawdown of greater than 10% in the equity markets, but we would not be surprised to see one sometime in the first half of 2022. In any case, volatility brings opportunity to add value through rebalancing portfolios, and we’ll be watching closely. We wish you and yours a very prosperous 2022. 

2021 3rd Quarter Update

Top Headline for Q3: Inflation and a Mini-Taper-Tantrum

For the first time in a long time, risk returned to the equity and bond markets. The Federal Reserve began hinting about “tapering” (i.e. slowing its program of monthly bond buying), and at the same time, it’s becoming increasingly clear that inflation is proving more persistent than expected. The combined effect of these factors is starting to cause some strain in the interest rate and bond markets and thus is causing some rumblings in the equity markets. 

Below is a YTD chart of the 10-year yield. This chart reflects what we think has been three distinct time periods for the treasury market and equity markets. The first quarter saw a spike in the 10-year yield, peaking on March 31st at 1.75%, as optimism for the economy reopening increased during the vaccine rollout. During this time period Value (LCV) significantly outperformed Growth (LCG). Then, the 10-year yield dropped from 1.75% down to 1.17% in early August. During these four months Growth significantly outperformed Value. One factor driving down yields was the increase in the COVID-19 Delta variant, which raised concerns about the economy slowing down again. As Delta variant numbers began to peak and booster shot information emerged, the 10-year yield started to turn up again. Higher P/E segments of the market (generally, Growth and Technology) tend to perform more favorably in lower interest rate environments, whereas lower P/E segments of the market (Value and Financials, for example) tend to outperform during rising interest rate environments. As such, clients have likely noticed that we have made some adjustments to portfolios during these changes throughout the year.

As an additional illustration, the YTD chart below from DailyShot.com shows the general inverse relationship between the US 10-year and the Nasdaq 100, which has a heavy tilt toward Growth and Technology. 

With continued tapering likely in the coming twelve months and inflation proving persistent, one would expect continued volatility in the markets. With volatility comes opportunity for those with good risk-management discipline. We will continue to rebalance portfolios in response to increased volatility in an effort to capitalize on short-term drops and spikes in price.

General Market Update

US Equities:  The S&P 500 Index finished the quarter +0.2%; however, this doesn’t tell the full story. The first two months of the quarter were strong with the S&P 500 rising as it had for much of the year before pulling back sharply in September (down almost 5%). September’s pullback was mainly driven by the S&P 500’s heavy technology exposure as the Nasdaq composite was -5.3% for the month. The Nasdaq Composite ended down 0.4% for the quarter while the Russell 2000 Index dropped 4.6%. During the quarter, Large Cap Growth outperformed Value as the Vanguard Large Cap Growth ETF (VUG) was +1.3% while Large Cap Value (Schwab Large Cap Value, SCHV) was -0.8%.

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 1.9% in Q3, and the Schwab Emerging Markets ETF fell 7.9%. Emerging market equities were hurt by a dramatic fall in mega-cap technology stocks in China. The Chinese government continues to take action that is unfavorable to its large technology companies. These actions include tightening regulations, forcing break-ups of conglomerates and cracking down on anti-government speech. The Chinese government has injected a lot of uncertainty into its equity markets and investors are clearly concerned. 

Fixed Income and Credit: The 3rd quarter was a quiet one for the corporate bond market despite the sharp movement in interest rates. Both short and long bonds were generally flat for the quarter. It’s clear that the government bond buying program continues to have a stabilizing influence. 

Commodities and Precious Metals: We continue to see price volatility in commodities as geopolitical tensions remain elevated and supply lines remain strained. However, it appears that the near-term COVID-driven peak in commodity prices is behind us. Much of the “transitory” inflation can be found in this category. In response to rapidly rising interest rates, precious metals and other inflation hedges pulled back slightly during the quarter. However, the global bond market still has over $15 trillion in bonds that are producing “negative yield” when factoring in inflation. Therefore, the short-term sell-off may prove to be a buying opportunity.      

A Look Ahead

As we’ve stated for several quarters now, all eyes remain on the Federal Reserve. Given the movement in inflation and rates, one would expect much more price movement in bonds. However, we’re not seeing it. Why? The Federal Reserve continue with “dovish” policies (i.e., low interest rates and bond buying among others). We think this will continue to be favorable for equities. The bond buying has artificially inflated bond prices, especially in the higher-risk (“high-yield”) segment of the market. Without the support, we would likely see lower bond prices, higher yields and, consequently, increased volatility in other risk assets. 

So, when do they stop or slow these policies? Among financial experts, the general consensus is that the policies will slow or abate only when the Federal Reserve is forced to alter them. If that is true, then it’s likely that persistent inflation will be the only reason that they may act. We’re starting to see some of that, and Chairman Powell’s recent comments acknowledge that it’s officially “above target.” Our guess, based on Federal Reserve comments, is that we will see the tapering of the bond buying to begin in the coming quarters. However, it is expected that the tapering will be very slow and that raising rates may be quite a ways off. One should pay close attention to inflation, as any major shift on that front could cause the Fed to act more quickly.

We continue to see volatility in the near-term. It’s going to be a messy process to wean off such a high level of government support. Bonds are likely to gyrate as investors try to make sense of any changes. Also, the overall backdrop of low interest rates and light regulation is favorable to stocks, but a changing interest rate environment could outweigh any good news on that front in the short-term. It’s also worth noting that fiscal austerity seems to be the last thing on anyone’s mind right now. As we finish this summary, the US bureaucrats are arguing over a rise in the federal debt limit. They’re spending money at an unprecedented pace and there appears to be no end in sight.

Patina Wealth’s Spookiest Top 10 List

Fall is here, pumpkins and gourds are overflowing your neighbor’s porch and pumpkin-spiced everything is on the menu. This means Halloween is right around the corner! It’s time for Patina Wealth’s Spookiest Top 10 list!

#1 – Being invested in a “load” mutual fund

Did you know that if you are invested in a mutual fund that has a “load” attached to it (its last two ticker symbols are usually AX or BX), the broker who sold that to you most likely received a sales commission? There are several different kinds of “loads”, but, the most common are front-end or back-end loads where the sales commission either happens when the client first invests or when shares are redeemed. Patina Wealth believes this is a clear conflict of interest.

#2 - Not knowing your portfolio allocation details

A diversified portfolio means having exposure to multiple asset classes. A portfolio that is invested in different segments of the market can help buffer volatility during market drawdowns. And, it can help create rebalancing opportunities. We think it helps to have holdings in your portfolio that target specific areas of the market. If your portfolio holds a fund that markets itself as being “balanced”, or, having both stocks and bonds together you likely have found it nearly impossible to know what areas of the market the fund is invested in. Very spooky!

#3 – Not working with a fiduciary

Yikes! Not working with a financial advisor who is obligated to make investment recommendations that are in your best interest can be very scary! Unfortunately, conflicts of interest are far too common in the investment industry. Working with a fiduciary can help make sure you are working with somebody who is putting your interests ahead of their own.

#4 – Investing in an expensive mutual fund

There is a lot of research showing how most actively managed mutual funds fail to beat their benchmark. One of the reasons? High fees. Yikes.

#5 -Taking too much or too little risk

It’s not uncommon for an investor to not know what their appropriate ratio of stocks to bonds should be. A person who is nearing retirement may feel like they should drastically reduce their stock exposure, even though they may need their investments to continue to work for them for another 20-30 years. Or, they may have too much stock exposure, leaving them vulnerable to big portfolio drawdowns. There are a lot of factors that should be taken into account including their own risk appetite, time horizon, or how much they are currently withdrawing to help with living expenses. Working with a fiduciary, actively monitoring your risk exposure throughout the year and having a financial plan in place can help answer these questions.

#6 – Making emotional investment decisions

Seeing your portfolio dip during market pullbacks can be very scary. It is easy to want to sell your holdings out of fear of them dropping more. But, making short-term emotional investment decisions can be even scarier because they can have significant long-term repercussions.

#7 – Not knowing how your financial advisor is paid

A fee-only fiduciary financial advisor should clearly show how he or she is paid. This isn’t always the case when working with advisors or brokers who aren’t fiduciaries. Some are compensated by the funds they invest their clients into, receiving “kickbacks”. This scenario makes it hard to know exactly how much they are getting paid. Very scary!

#8 – Not knowing what you’re invested in

Have you ever invested in something not knowing exactly what you are buying? That can be very spooky. Before investing your hard-earned money, you should know exactly how it fits into your overall portfolio.

#9 – Inadvertently realizing capital gains or incurring withdrawal penalties from retirement accounts

When you sell an investment can make a big difference when tax time comes around. Paying short-term capital gains versus long-term capital gains can be frightening. And, mistakenly withdrawing from your 401(k) or IRA before you are allowed to can bring an unwelcome tax bill and early withdrawal penalty.

#10 – Not saving in the most appropriate investment vehicle

ROTH IRAs, Traditional IRAs, Traditional 401(k)s, ROTH 401(k)s, 529 savings accounts, taxable brokerage accounts, the list of different investment accounts goes on. They all provide different advantages and some are more appropriate for each person than others. For example, will your income be higher in retirement than it is now? Are you taking advantage of tax breaks in certain investment vehicles? Properly planning right now can make a big difference in the future. Working with a fiduciary can take the fear out of retirement planning!

If any of these sound familiar to you, we can help!

The Inflation Tug-of-War

There is a lot of “inflation” talk in the press today. Prices of houses, used cars and certain grocery items appear to be soaring while the Federal Reserve Bank assures us that any inflation is “transitory” (i.e., temporary). But, are they right? Make no mistake, we’re at an interesting inflection point regarding inflation that could have a tremendous impact on our lives. So, let’s take a deeper look at where things may be headed.

So, first off, let’s answer the question – “What causes inflation?” Economists have differing opinions on this one but they tend to agree that inflation can be “demand-driven” or “supply-driven.” Demand-driven inflation results from too many people demanding the same goods and services while production can’t keep up. This situation may arise in economies that are doing really well to the point of “overheating” (i.e., extremely low unemployment, high wages, etc.) and is especially common when a country’s population skews toward the consumption-heavy age cohort (i.e., 30-50). Supply-driven inflation tends to refer to inflation caused by “supply shocks” which are generally short-term disruptions in production and supply-chains caused by things like geo-political tensions, natural disasters and pandemics. 

People who believe that our current inflation is transitory tend to argue that the cause is, in fact, the COVID-19 Pandemic which has wreaked havoc on global supply chains and the labor supply. Moreover, they point to an aging population, rapid technological advancements and high levels of debt as significant deflationary headwinds in the developed world. They are correct on these points and, under normal circumstances, the transitory argument would seem to be the winner. However, another key factor in the ongoing inflation debate revolves around the money supply which has grown at truly remarkable levels. The chart below shows how significant this growth is.

Credit: FRED Economic Data

Governments have been aggressively borrowing with most of the debt being purchased by central banks leading to a “monetization of the debt” and growing money supplies. Many argue that, while devaluing a currency in this way may create tailwinds for inflation, it doesn’t necessarily cause inflation (i.e., it doesn’t create demand). But, we’ve never seen anything like this before so history offers no lesson for what we are now experiencing.

Given that we are in the midst of a grand experiment by governments and central banks, it’s important to monitor the impacts closely. One impact that now appears obvious is that, without government intervention, the stock market would be much lower than it is today. The same can be said for the bond market and commercial real estate. In general, it is common consensus that we are experiencing inflation in risk assets of all stripes. The “wealth effect” caused by rising portfolio valuations, may be carrying over to other areas such as housing. As the chart below shows, we’ve seen a rapid recent spike in the median home value in the United States. It’s likely that we will see “wealth effect” inflation crop up in other areas, especially among goods demanded by the world’s wealthiest who have been the primary beneficiaries of this surge in values.

Credit: FRED Economic Data

So, where does inflation go from here? The core environmental factors (aging population, technologic advancement, etc.) are deflationary while short-term disruptions (e.g., COVID-19) are inflationary. Meanwhile, government intervention in the form of the rapidly-growing money supply and perpetually low interest rates certainly raises the risk of inflation. In short, it appears that the federal governments hold a lot of control. While it’s impossible to predict future government actions, given the rising risk of inflation, investment portfolios may benefit from some adjustments. Inflation can appear quickly and can be very detrimental to many asset classes. 

Projecting the equity market is perhaps the trickiest endeavor of all. The increase in money supply, in combination with historically low interest rates, has clearly positively impacted the equity market. It would likely continue to do so if these conditions persist. But, when does it end? The federal governments have created a risky set-up for equity markets in that any reduction in money supply or increase in rates could create a stampede for the door. As such, it’s important to hold quality assets through a diversified portfolio that you’re comfortable holding through any market conditions. 

2021 2nd Quarter Update

Top Headline for Q2: Continued Rotation with Rising Fed Dependency

In some ways the second quarter was a continuation of the first. Value trades continued to perform well with more economically sensitive sectors like energy, financials, and industrials pushing higher. Energy proved to be the top performer year-to-date with XLE up 45.1% through June 30th. However, it’s also noteworthy that all equity sectors performed well. The overall stock market has now been up for 6 months in a row, 5 quarters in a row and it seems to be making new all-time highs on a weekly basis. It’s becoming more and more clear that Federal Reserve Bank actions are having a massive impact on markets. The increased liquidity and interest rate impact from the continued $120 billion in monthly bond buying, along with guidance surrounding interest rates, is proving to be a massive tailwind for risk assets.

General Market Update

US Equities:  The S&P 500 Index finished up 8.2% for the quarter and the Nasdaq Composite was up 9.5%. The Russell 2000 small cap index lagged a bit – rising “only” 4.1%. Growth made a late 2nd quarter comeback, benefiting from a drop in yields during the quarter. The Vanguard Large Cap Growth ETF (VUG) ended the quarter up 11.7% while its Value counterpart, Vanguard Large Cap Value (VTV) was up 5.1%. Two other notable 2nd quarter “comebacks” were the Technology (XLK) sector, which was up 11.4% in 2Q after only being up 2.4% in 1Q, and Cloud Computing (SKYY), which was up 10.7% in 2Q after being up 0.8% in 1Q. Despite this Growth comeback, several Value subsectors, which Patina Wealth portfolios have exposure to, performed well during Q2. Energy (XLE) ended Q2 up 10.9%, putting it up 45.1% YTD and Financials (XLF) ended Q2 up 8.2%, putting it up 25.5% YTD. The stock market is clicking on all cylinders at this point benefitting from a number of tailwinds including fiscal and monetary support from the federal government and continued good news related to the COVID-19 virus in the United States.

Data Source: Yahoo Finance

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 4.9% in Q2 and the Schwab Emerging Markets ETF was up 3.5%. The international market has lagged US indices in recent quarters likely due to better news on the US COVID front, including increased vaccine penetration and general reopening optimism. Emerging markets continue to have attractive relative valuations but the emergence of COVID variants is a greater threat in the sector and will likely limit growth for a bit longer. For example, the daily COVID numbers in India has subsided but saw a substantial spike during Q2.  

Fixed Income and Credit: The 2nd quarter was an interesting one for the bond market. After a very rough first quarter where bond prices tanked on “re-opening” optimism, rates tended to trend downward in Q2 as bond prices generally rose. After seeing the 10-year treasury bond yield rise from 0.92% to 1.75% during the 1st quarter, it fell back down to 1.44% by the end of Q2. This was a bit of an unusual move as the equity market optimism and inflation talk would normally lead to falling bond prices and rising yields. It’s possible that Q1 may have been an overshoot of inflation expectations leading to a short-term decline in Q2.

Data Source: Yahoo Finance

Commodities and Precious Metals: Many commodities continued to rise during the quarter as supply chain issues resolve slowly. It remains unclear whether some of these price movements will prove “transitory” as indicated by the Federal Reserve Bank. Precious metals continue to trend sideways as uncertainty persists on the inflation front and risk assets continue to perform well, offering an attractive alternative. Real yields continue to be negative which would normally be a bullish environment for precious metals but the relentless rise in risk assets is limiting investment flows into the category.

A Look Ahead

It feels like we’re getting near the end of the easy money policies from the Federal Reserve Bank. They’ve indicated that they are not likely to raise rates for quite some time but they also indicated that a tapering of their bond buying may be in the cards for the 2nd half of 2021. It’s tough to tell (1) if they’re going to follow through on this action and (2) if so, what impact it will have on markets. Using the last 10 years as a guide, the stock market will not react favorably to any tapering or talk of raising interest rates so it’s important to watch Fed actions closely.  

It’s also noteworthy that political pressures are building that could adversely impact equity markets in the long-term. For example, there is further discussion around increased corporate taxation, increased minimum wage, and a general disdain for a rising “wealth gap” that could lead to policies disadvantageous to large businesses. There is also a renewed call for updating of the anti-monopoly policies which could threaten the FAANG complex and other large cap companies. 

It would not be surprising to see some increased volatility in the coming quarter. It’s not normal for equity markets to go up in a straight line and we’re long overdue for a pull back. However, the overall landscape is still very favorable to stocks and we’d view any pull back as an opportunity. Rock bottom interest rates, continued Federal Reserve Bank bond buying, aggressive federal government spending packages and a slow-moving congressional process suggests a bright near-term future for equities. Plus, COVID news continues to be positive and consumer enthusiasm is strong, leading to what will likely be historic GDP growth.

So, where does the rubber hit the road? You can’t get something for nothing and it’s clear that as a nation we’re spending money we don’t have. That is, we’re running massive deficits leading to record federal debt levels and increasing the money supply/devaluing the currency to deal with it. One would expect this environment to be inflationary. Clearly, we’re seeing inflation in some areas (e.g., risk assets, home prices, car prices, etc.). Our bet is that, in the long term, asset inflation is the path out of the current debt dilemma for Federal Banks. That is, there is no obvious path to paying down the debt through austerity so it’s likely that federal policy will allow inflation to rise well above prevailing interest rates in an effort to deflate the relative size of the debt. This tactic may also involve continued bond buying as a form of “yield curve control” to ensure that interest rates (aka debt costs) do not grow to an unsustainable level. Given this backdrop, real assets and precious metals will likely see renewed interest as an investment when/if equity markets cool down a bit. 

Value Investing - Rising From the Dead

Buying “Value stocks” (i.e., public companies at reasonable prices relative to fundamentals) has been a hallmark of investing for over 100 years. Legendary investors like Warren Buffet parlayed the concept into billions of investment profits and many academics, like the famous Eugene Fama and Kenneth French, find it to be one of the primary factors explaining future stock outperformance. So, what has been happening to Value since the “Great Recession” – a period marked by the greatest underperformance of Value stocks versus Growth stocks in history? And, where do we go from here?  

That last 10+ years have not been kind to Value. Over the last decade, the Russell 1000 Growth Index gained about 17% per year while the Russell 1000 Value Index gained about 10% per year. The outperformance has been so consistent and dramatic that some have claimed that “Value is dead.” It’s hard to argue with the results, especially when recent performance has been so lopsided. In 2020, The Vanguard Russell 1000 Growth ETF, VONG, was +38.3% while its Value counterpart, the Vanguard Russell 1000 Value ETF, VONV, was only +2.6%.

To understand this relative outperformance, let’s first look at some of the causes. We would argue that the primary driver of the general outperformance of Growth over Value has been government stimulus. Growth stocks are heavily impacted first and foremost by interest rates. Growth stocks expect cash flows to materialize further into the future than Value stocks so, when rates are low, there is less of a negative impact from discounting those cash flows to the present. As you may recall, the Federal Reserve Bank lowered the benchmark interest rate to near 0 coming out of the Great Recession and generally left it there for the better part of the last 13 years. They lifted rates a bit from 2015 to 2019 but the move was gradual and the benchmark rate barely rose during the period – peaking at just under 2.5%. 

In addition to lowering rates, the Federal Reserve bank created the additional tailwind of increasing the money supply by buying bonds in the open market. These moves created an “easy money” policy where capital was generally free-flowing to large companies. Finally, in response to the COVID crisis, the Federal Reserve Bank began buying bonds of individual companies including behemoths like Apple. The net effect of this activity was to drop borrowing costs for large Growth companies to barely above US Treasury rates. In summary, cash has been easy and cheap for large public companies – a situation that helps all companies but is especially bullish for Growth stocks.

While rates remain low, it seems the market may now be predicting a possible regime change. So far in 2021, we’ve seen a noticeable rebound of Value stocks over Growth. For example, the deep Value energy sector ETF (XLE) is up 31.7% year-to-date through the end of April versus 7.7% for the high Growth tech sector ETF (XLK). A similar story is seen in Financials (XLF) which is up 23.5% and Industrials (XLI) which is up 15.5%. So, are we seeing a short-term blip in performance or a new secular trend?

Part of the recent outperformance of Value is simply optimism coming out of 2020. The same sectors that were beaten up in 2020 (e.g., Financials, Energy, etc.) are now some of the top performers. As the world continues to gain control of the COVID virus and economies re-open it stands to reason that the beaten-down sectors would see some immediate recovery. Financials are also benefiting from a steepening yield curve while the energy sector is seeing rapidly rising demand from renewed interest in business and leisure travel. 

As we look forward, much of the market performance will depend on the actions of the Federal Reserve Bank. If rates stay low, Growth is likely to continue to be a top relative performer but, if not, one would expect earnings multiples to compress which would be a huge headwind for the sector. Overall, our bet is that we’re long overdue for some sustained Value outperformance. We see a number of tailwinds for Value relative to Growth including (1) the price to earnings spread between Value and Growth is extended relative to historical norms and (2) we’re seeing strong economic and employment Growth – meaning the risk of inflation has increased along with the prospect of future interest rate increases. 

2021 1st Quarter Update

Top Headline for Q1: Investors Predict a Recovery

The most noteworthy price action of the first quarter occurred in long-duration bonds where a sharp decline suggests continued optimism among investors. With COVID vaccine rollouts accelerating and more “easy money” policies from federal banks throughout the world, investors have hopped on the reopening bandwagon. As investors anticipated a potential pick-up in business activity and possible inflation, long duration bonds saw significant declines. The 30-year US treasury bond plummeted about 15% - an abrupt and massive move for a market that had been relatively quiet. 

The bond market action and investor enthusiasm carried over to the equity market. 2020 “winners” (i.e., high growth companies that saw massive price/earnings multiple expansion) began to move sideways or down. Growth companies did not react well to increasing interest rates as their future value is more sensitive to higher rates. The 10-year treasury started 2021 at 0.92% and ended the quarter at 1.75%. Investors shifted to previously beaten-up sectors such as financials, industrials and energy.  Patina Wealth investors benefited from this shift as we began shifting some portfolio allocation from Growth and Technology into Financials and Industrials beginning in 4Q 2020.

General Market Update

US Equities: The S&P 500 Index finished up 5.8% for the quarter, while the more growth-oriented Nasdaq Composite was up only 2.8%. After Growth significantly outperformed Value last year, the opposite happened in Q1. Schwab’s Large Cap Value ETF was +9.7% while Schwab Large Cap Growth was only +1.1%. The big winner for the quarter was small capitalization stocks which were up 12.4%. The small-cap segment benefitted from a number of tailwinds including, (1) a heavy value orientation given its exposure to financial service companies and (2) a massive run up in heavily shorted growth-oriented stocks stemming from the Gamestop retail investor frenzy. Small-cap performance, especially small-cap growth, is likely to be a bit choppier going forward as many of these heavily-shorted names are likely to return to appropriate prices. US equity market valuations generally remain elevated relative to historical norms driven mostly by the growth sector whereas many value-oriented sectors are trading at more reasonable valuations.

International and Emerging Market Equities: The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 4.5% in Q1 and the Schwab Emerging Markets ETF was up 3.7%. The developed international market has struggled in recent years relative to tech-heavy US large-cap indices which generally prove more attractive in a low interest rate environment. If bond markets continue to trend down thereby lifting prevailing interest rates, we may see some renewed investor enthusiasm for the developed foreign equity markets. Emerging markets appear to be a bright spot for investors on a forward-looking basis where below average stock valuations, favorable demographics and positive GDP forecasts offer enticing tailwinds.   

Fixed Income and Credit: As mentioned above, Q1 2021 was a rough quarter for the bond market. Mid to long-term bonds saw substantial price declines. Corporate bonds faired a bit better than treasuries given (1) the re-opening enthusiasm and corresponding risk-taking that led to an exodus from the “safe haven” of US Treasuries and (2) the higher-yielding corporates are slightly less impacted from a rise in inflation expectations.

Commodities and Precious Metals: There was an unusual divergence in Q1 between commodities and precious metals. Most commodity sectors rose significantly while precious metals saw a substantial decline. Inflation expectations certainly rose during the quarter which generally would be favorable to both sectors. However, the rise in bond yields was a drag on precious metals. More specifically, precious metals tend to perform best when “real yields” (i.e., bonds yields net of inflation) are negative. In Q1, interest rates surged higher such that real-yields outpaced inflation expectations leading to a sell-off in precious metal. As we will discuss below, action by federal banks going forward will be a key driver of performance for these segments.

A Look Ahead

It seems like we’re beginning to sound like a broken record, but government intervention continues to be one of the largest drivers of market performance on all fronts. Starting first with the bond market, one has to try to predict government action in order to forecast bond prices. For one, the Federal Reserve Bank impacts interest rates by adjusting the Federal Funds Rate. As we’re often reminded, Jerome Powell isn’t even “thinking about thinking about raising rates,” but the market may force the hand of the Federal Reserve Bank. That is, if growth and inflation expectations accelerate, bond prices will continue to plummet thereby driving bond yields and prevailing interest rates higher. Federal officials will then have to make a decision (i.e., allow rates to continue to climb thereby putting pressure on many businesses or step in with some form of intervention). Intervention at that point is likely either (1) to raise rates or (2) to increase their bond buying activities to support bond prices and cap yields. So, what is the most likely outcome and where are bond prices going? Our bet is that the Federal Reserve Bank will continue to do nothing until they are forced to do something. That forecast would suggest bond prices may continue to trend lower for the foreseeable future before eventually stabilizing through increased bond buying. If that occurs, we’d likely see a surge in demand for inflation hedges and assets that perform well in a negative real-yield environment.

On the equity market front, it’s clear that continued positive vaccine news and easy-money federal policies are positive for the market. The real question remains: When will these policies end and what happens then? In general, equity market valuations remain inflated by historical standards. But, we continue to have unprecedented monetary stimulus (i.e., “lower for longer” interest rates and fiscal stimulus via massive direct payments to individuals and businesses). As long as these continue it should be good for the equity market. Our belief is that, in the near term, we will continue to see improvement in previously beaten down sectors. In the growth category, investors need to be more selective where some high quality companies (e.g., Apple, Microsoft) are cash heavy and well positioned for any outcome whereas others with high multiples and weak balance sheets are likely to struggle in a rising rate environment.

In summary, the “fed watching” will continue throughout 2021. If the Biden administration follows through on the planned fiscal spending, it will be good for the economy in the short term. This activity is likely good for the stock market, but not good for the bond market which will likely continue to sell off on inflation fears and risk taking via higher equity allocations. High growth stocks, especially with weak balance sheets, become an increasingly dangerous investment with improving economic conditions and the prospect of rising interest rates to follow. We continue to be bullish on precious metal and commodities in the long-term given the risk of inflation generally and the potential for negative real yields.  In the short run, precious metals are likely to continue to struggle as bonds sell off and bond yields drift higher. Lastly, sentiment matters, and a continued vaccine rollout leading to reopening enthusiasm should create a favorable environment for all risk assets.

Is The Bond Market Predicting The Future?

In recent weeks, we’ve seen a sharp pullback in U.S. bond prices and a corresponding increase in yields. For example, at the beginning of 2021 the 30-year treasury bond was yielding 1.66% as compared to a March 15 yield of 2.38%. As far as bond market moves go, that is a substantial change over a short period of time. It is a particularly interesting move given that the Federal Reserve Bank hasn’t made any rate changes and hasn’t alluded to any rate changes. So, why might the bond market be moving?

The price movement in the bond market is generally a result of either (a) a change in perceived risk, (b) a prediction about the direction of benchmark rates set by the Federal Reserve Bank or (c) a prediction about what is happening related to the overall economy. So, which future is the bond market foretelling?

In our view, it’s unlikely that this move has anything to do with risk (i.e., that bond investors are requiring a higher yield because of higher risk). The reason that hypothesis seems unlikely is that equity market risk-taking is off the charts. Sentiment indicators are showing that investors are in risk-taking mode and the recent success of various IPOs and other tech companies without earnings supports this thesis. It is somewhat more plausible that the market is now expecting a potential increase in rates by the Federal Reserve Bank but even that thesis is flawed. For one, the Federal Reserve Bank has explicitly stated that they’re “not even thinking about thinking about raising rates” and history indicates that central banks are extremely slow to raise rates coming out of a recession. Given that we’re only partly through a vaccination rollout and just starting the economic recovery process, it’s safe to say that rates aren’t likely moving anytime soon. So, it seems that the most likely cause of the bond market reaction is a prediction of an economy that is picking up steam and that may lead to an increase in capital demands and potentially inflation.

The bond market yields generally start rising ahead of an economic acceleration because an improving economy eventually pushes yields higher. For one, good economic conditions increase the demand for capital and, in some respects, rates reflect the demand for money. Also, an improving economy tends to accelerate the demand for goods and services which can cause an increase in inflation. Any increase in inflation is generally going to be reflected in bond yields given that investors will require bond yields to exceed inflation rates so that “real yields” (i.e., yields minus inflation) remain positive. 

So, how might portfolios be adjusted given the rise in yields? Rising yields are most punishing to growth equities. The reason for this is that growth companies have earnings that are pushed furthest into the future and any increase in the discount rate for those earnings lowers a given company’s present value. We’ve seen this play out in recent weeks as the high growth technology sector has fallen while yields have risen. In this type of environment, value and high dividend stocks tend to come back into favor. Moreover, industries that are heavily impacted by economic cycles can see improvement (e.g., basic materials, manufacturing, banking and energy). After leaning into Growth and Technology coming out of the pandemic low last year with positions like Technology Select Sector SPDR (XLK), Invesco QQQ Trust (QQQ), First Trust Cloud Computing (SKYY) and Vaneck Semiconductor (SMH), we began shifting to a more “Value” tilt beginning in late 2020. Client portfolios have seen a reduction of Growth holdings and the addition of more traditional Value holdings in the form of Financial Select SPDR (XLF), Industrial Select SPDR (XLI) and an increase in a core Large Cap Value holding.

Inflation, if it materializes, will likely be very positive for commodity investments and precious metals. We’ve certainly seen a move higher in commodities but precious metals have actually fallen during this period. It’s important to note that precious metals are more impacted by “real yields” than the general level of inflation. Given that bond yields have risen so aggressively, real yields have remained positive and have adversely impacted precious metals. If we see a stabilization of yields with a continued rise in inflation, precious metals are likely to perform well.

Director of Patina Wealth’s Richmond Office Shares His Family’s Approach to Investing

In meetings with clients and prospects, frequently the conversation centers around the state of the economy, current market trends, asset allocation strategies, etc.  Rarely do I receive the question: “How do you invest your money?” 

I’ve recently read two fantastic books, The Psychology of Money by Morgan Housel and How I Invest My Money edited by Josh Brown and Brian Portnoy.  While both books are quick reads, they are thought provoking nonetheless.  The former is largely centered on the unique forces that affect one’s relationship with personal finance and investments.  The latter is a collection of short essays by investment professionals that answers the very question of how they invest their money. 

Therefore, the question begs, “How do I invest my money?”  The question really should read, “How do WE invest OUR money?”, as all financial decisions are a group effort in our household.  We are Co-CEOs in every aspect of our lives.  That being said, the short answer is, “right along with my clients.”  The vast majority of our retirement assets are invested in broadly diversified low-cost equity and fixed income exchange traded funds (ETFs).  We own the same funds, in roughly the same percentages as clients of similar risk tolerance.  We believe this approach provides the greatest opportunity for long term success, and we are all in on this.  We dollar cost average into these accounts on a monthly basis.  We also contribute monthly to a 529 account for our son that invests in the broad market via a low-cost index fund.  I don’t closely track the performance in this account; the important part is consistent monthly additions.  The cost of education is on the rise so this affords the opportunity to stash money away in a tax efficient manner. 

Similarly, our taxable accounts consist largely of index ETFs.  A smaller portion (~10%) are held in individual stocks of companies we know, use and trust.  We don’t plan to sell any of these names.  The goal is to hold for the long haul and allow the power of compounding to take root.  Because of this, we keep a fixed amount of cash in savings to help pay for any unexpected expenses that might arise.  Less than 1% of our liquid net worth is held in crypto currency. 

This plan works for us.  We are committed to this strategy and are confident the market and global economy will create value over our lifetimes.  That being said, there are no “right” answers in investing.  I know everyone is different, and success is defined uniquely for each individual or family.  My goal in helping clients is to find the strategy that makes them comfortable, works best for their family and provides them the best odds of achieving their own long-term success. 

John Mumper

Director, Patina Wealth

Richmond, VA

Nothing in this document is intended as investment, legal, accounting, or tax advice, and is for informational purposes only.

Post-Georgia Senate Runoff Election Thoughts

Blue Wave, Green Policies

Recently, the voters of Georgia elected two Democratic Senators in an upset win over Republican incumbents. Although the “Blue Wave” never materialized in the last election, this recent victory was a significant one for the Democrats who now hold the presidency and control majorities in both houses of congress. The increase in Democratic control could have substantial policy implications that may affect investment portfolios. 

First off, it’s clear that President Joe Biden has placed a “green” agenda front and center. Two of his first moves in office were to rejoin the Paris Agreement for reducing carbon emissions and announcing that all government vehicles, a fleet of nearly 650,000, should be transitioned to battery power. These moves were a blow to the already beaten-down fossil fuel industry that was suffering from a massive COVID-driven demand drop. On the flip side, any investments related to new-era energy surged such as electric vehicle stocks as well as the components of electric vehicles such as cobalt, lithium, nickel and other metals that are instrumental in battery construction. Moreover, while it’s clear that the future of energy will include a continued reduction in fossil fuel, the transition will take time. Given the COVID demand drop many drilling operations were taken off-line and a short-term spike in oil-based fuel prices is a very real possibility with any sudden surge in demand. Such a surge would be welcome news to energy giants Exxon, Chevron, BP and transporters like Enbridge and Energy Transfer Partners all of which remain depressed.

Another key area of focus for the Biden administration will be policy related to wealth inequality. Wealth inequality has taken center stage during COVID as the stock market surge widened the wealth gap as billionaires added $4 billion in wealth while many remained unemployed. Biden has already proposed raising the minimum wage for federal employees to $15 per hour and many politicians are calling for broader application of minimum wage policies as well as mandated benefit increases and improved health plans. It’s likely that other pro-labor policies will have wide support from the current administration. The implication here is that companies with a significant labor force may begin to see margins squeezed. Companies like Walmart, Amazon, Kroger, Home Depot, Starbucks and Target that have large numbers of lower-paid employees could be facing declining margins and adverse stock price impacts.

It is also fair to expect higher taxes in general as the government attempts to fund spending and, perhaps, begins to see some pressure to work back toward a balanced budget. As you may recall, the Trump Administration lowered the corporate tax rate. Given the substantial profitability of U.S. corporations and wealth gains by corporate leaders in recent years there will likely be support for reversing many of those changes. Of course, increased taxes will further squeeze business profitability. While there is not an obvious “loser” with this change, it’s noteworthy that tax policy combined with pro-labor policy is likely to disproportionately strain businesses with weak balance sheets and poor cash flows. We’d advise putting an emphasis on the “quality” factor in equity portfolios and begin to minimize exposure to weaker companies including “zombies” (i.e., those with cash flows insufficient to cover interest payments) that have relied on cheap debt to survive. 

It’s also noteworthy that continued support payments to Americans are likely. Biden called the most recent COVID relief bill a “down payment” suggesting that it was not sufficient and that more would be coming. The implications of these continued payments are tricky to assess. The payments were so substantial in 2020 that America’s disposable income collectively was actually higher in 2020 than if COVID had not happened. Moreover, we now have substantially more in savings than we did at the start of the pandemic. If the virus mutates or vaccines are delayed we could expect continued lockdowns and spending that mimics 2020. That is, customers will further increase savings deposits, work from home, order take-out, shop on-line, play video games, log hours on social media, do yard work and buy a lot of groceries. In that world, the winners are the 2020 winners (e.g., Amazon, Walmart, Doordash, Lowes, Zoom, Microsoft, Twitter, etc.). However, if we regain freedom of movement the build-up of savings could create an economic surge. Most notably, energy stocks could come roaring back as well as travel, airlines, tourism, various real-estate sectors and restaurants. 

Given the enormous COVID support bills, inflation presents the biggest “wildcard” for all of us on the investing front. With Democratic control, Janet Yellen as Treasury Secretary and Jerome Powell as head of the Federal Reserve, we are likely faced with continued “easy money” policies. Such policies could contribute to an eventual inflation issue. If/when high inflation materializes, it will collectively hurt stocks as consumers divert spending to basic necessities. Moreover, if inflation climbs too high, the Federal Reserve would be forced to raise rates leading to a potentially allergic reaction by the equity market. Given the potential for inflation, some allocation to real-assets, commodities and precious metals continue to make sense for investment portfolios, in our view.

In summary, we think the prospect of continued stimulus in the short-term will keep the economy moving given that it will largely convert directly to consumer consumption. This will probably create favorable headlines for the equity market in the short term. Moreover, the build-up in savings is likely to create a short-term economic surge as COVID impacts dissipate. However, the medium term picture is less rosy for the equity market. For one, government spending is going primarily to consumption and not projects that improve productivity or production capacity. That will have adverse medium-term GDP growth impacts. Moreover, companies will eventually face increased margin pressure from rising labor costs and higher taxes while also dealing with a renewed call for anti-monopoly action. Lastly, the steady flow of money into the system is creating the potential for high inflation – a condition we have not faced in 40 years. So, in summary, placing an emphasis on quality companies is critical along with adding investments that will provide some hedge against inflation risk

2020 4th Quarter Update

Top Headline for Q4: COVID-19 Vaccines

As 2020 ends, it is impossible to not breathe a small sigh of relief as the new year brings a renewed optimism about better days ahead. The emergence of several vaccines during the quarter was welcome news for all and the enthusiasm carried over to the markets. Pfizer, Moderna, Johnson & Johnson, and other medical companies worked quickly to find a vaccine for COVID. Our thanks go out to the vaccine developers who defied the odds and delivered several viable vaccines many months, if not years, ahead of early projections. Although many are still battling the virus, it is good to finally close the chapter on 2020 as we hope for a full recovery for those affected and rapid vaccine deployment to prevent further outbreaks.

As these medical breakthroughs began to emerge, the debate in D.C. about a potential second relief package continued. Many investors believed additional help was needed to bridge the gap to when vaccines would be widely available. As vaccines began to be administered to frontline workers in mid-December, a second assistance bill totaling approximately $900 billion was passed.

As we reflect on market performance in 2020, it is hard to not be a bit perplexed. COVID-19 was clearly one of the most economically damaging events to occur in our lifetimes, and yet, we experienced an “everything rally” where nearly all asset categories performed quite well for the year. Therefore, one is left to wonder – “How did that happen?” In retrospect, federal intervention had a dramatic impact on markets. It’s noteworthy that stock and bond price appreciation is not a stated goal of the Federal Reserve Bank or federal policy. Rather, the Federal Reserve seeks to achieve “full employment” and a 2% inflation goal while encouraging market stability. However, their actions went further than achieving market stability as word spread of a “Fed Put” (a reference to the perception that the Federal Reserve Bank simply would not let stock or bond prices fall). The perception of a Fed Put, combined with statements from Jerome Powell such as, “we’re not even thinking about thinking about raising rates,” seems to have led to widespread bullishness and some aggressive equity market buying. For example, retail investors opened over 10 million trading accounts during the year, increased their margin balances by 50% and invested in call options (i.e., made levered bets on stocks rising) at record levels. So, where do we go from here? More on that below. 

General Market Update

US Equities:  2020 has been a remarkable year. While COVID-19 cases around the nation continue to surge, and small businesses shut down in record numbers, the stock market looks ahead to life after the vaccine. After what was then an all-time high for the S&P 500 Index set on February 19th, the market plunged 35.4% before bottoming on March 23rd. This was the fastest bear market (i.e., 20% drop) in history. Then, as “Main Street” continued to struggle, Wall Street enjoyed its quickest bear market recovery in history. The S&P 500 fully recovered its price drop in only 126 trading days. The next fastest recovery was back in 1966/1967 when it took 310 days to recover. 

The S&P 500 Index finished up 11.7% for the quarter and 16.3% for the year. The Nasdaq Composite was the big winner for the year finishing up 43.6% after gaining over 15% in the quarter. Lastly, the small-cap Russell 2000 Index had one of its largest quarterly gains in history (appreciating 31% for the quarter and 18.4% for the year) which allowed it to narrowly pass the S&P 500 Index. Part of the equity story during Q4 was a rally among beaten-down sectors (e.g., financial firms and the energy sector). The financial ETF (XLF) finished up 23.1% for the quarter while the energy ETF (XLE) surged 28.3%. In comparison, the high-flying tech sector, a leader throughout the year, gained “only” 11.7% as measured by XLK. 

It’s noteworthy that Patina Wealth’s portfolios leaned into Growth and Technology coming out of the initial market meltdown. Client portfolios benefited from the additions of some specific sector exposure including Technology, Semi-Conductors, and Cloud Computing. From the market bottom in late March, Growth and Technology sectors have significantly outperformed the market. While we will continue to hold a diversified portfolio, we believe more Value oriented holdings may have a more attractive risk/return premium as the country begins to reopen. Client portfolios have recently seen the addition of a pure Financial sector holding, and a slight shift from Growth to Value, including a slight increase in Small Cap Value.

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 16.3% in Q4 and the Schwab Emerging Markets ETF was up 16.6%. The developed international market has been improving recently relative to the large-cap US indices mainly on account of the industry composition of the European market (i.e., it has a lower percentage of technology companies). If vaccine news remains positive and depressed industries continue to move back toward average valuations, it’s likely that these markets will continue to gain ground against tech-heavy US indices. Emerging markets are continuing to see a surge as economies continue to re-open leading to further improvement in manufacturing combined with strong economic results from China.     

Fixed Income and Credit: The US bond market saw an interesting divergence during the quarter as corporate bonds substantially outperformed treasury bonds. This movement is a further indication of renewed market confidence. As you may recall, treasuries dramatically outperformed early in the year as is typical during any period of market turmoil that leads to a “flight to quality.” In general, we don’t expect much price movement in the bond market and expect continued low yields. The Federal Reserve continues to drive the market in treasury securities where it has become the largest purchaser. Moreover, the plan to keep interest rates low indefinitely suggests no movement in bonds due to interest rate changes combined with very low yield. The one caveat would be inflation as increasing inflation expectations would push bond prices down and yields up (more comments on this below). 

A Look Ahead

Back to the question, where do we go from here? We’ve spent a great deal of time over the last six months listening to economists and other experts opine on this question. It’s clear that the rules of the game have changed. The current situation is a grand experiment to which history offers no guide. People have grown tired of the overuse of the word “unprecedented” in 2020 but it’s accurate especially regarding federal government intervention. For example, take the following into consideration, (1) the Federal Reserve bank has suggested interest rates will sit at zero indefinitely, (2) the money supply increased 68% in 2020 – the largest increase on record, (3) the Federal Reserve is the largest buyer of treasury bonds thereby artificially inflating the value of those bonds and further suppressing yields, (4) the federal budget deficit exceeded $3 trillion in 2020 which is the largest gap ever and 3 times the amount from 2019 which was already deemed excessive and (5) there is now growing acceptance of the concept of Modern Monetary Theory which suggests budget deficits don’t matter. The federal government was the number one factor driving market performance in 2020 and that’s not likely to change anytime soon. If they continue with accommodative policies, continued asset price inflation is likely. However, any tightening at this point would likely be devastating. For example, corporations added $1 trillion in non-financial debt to reach an all-time high of $11 trillion in 2020 and “zombie” companies (i.e., those that cannot pay interest on debt from cash flows) is at an all-time high. Many believe that rates simply cannot go up from here.

So, what does all that mean for the US stock market? Well, the proposition of low rates indefinitely is incredibly beneficial to growth companies with attractive returns on capital. Companies, like Amazon, are borrowing money at Treasury-bond-like rates and that is not likely to change anytime soon. The optimism, in fact, has led to a surging stock market and valuations that are among the highest in history. Moreover, the low rates delay corporate bankruptcies which otherwise might begin to trigger some selling. The greatest threat to the US equity market stability may come from social unrest and resulting policy change. There has been much buzz about economic inequality in 2020 driven by government actions. The US added over 50 new billionaires in 2020 as government intervention set the stage for a wave of highly priced initial-public-offerings. Moreover, existing billionaires added over $1 trillion in wealth during 2020 from surging stock performance while millions were unemployed from mandated shutdowns. It may not happen in 2021 given the predicted “split” congress, but it seems likely that higher corporate taxes, a higher top income tax rate and other forms of wealth-redistribution policies are likely in our future. There is also some discussion about unfair competition and monopolies that could be disruptive to the market in 2021 as it has some bipartisan support. 

The big unknown for 2021 is inflation. When/if inflation picks up steam, it will have profound effects on markets. Fixed income investments, like bonds, would attempt to drop in price in an inflationary environment for yield to keep pace with inflation. The Federal Reserve, as was done in Japan, may then institute “yield curve control” to prevent any bond price declines/rate increases so bond impacts may be muted. Inflation is also not generally good for the stock market though some businesses (e.g., higher margin/low headcount) do better than others. Coming out of 2020 with high unemployment and other deflationary impacts from COVID-19, the risk of inflation would seem low. However, given a growing money supply, an extremely accommodative Federal Reserve, less globalization and a growing support of Modern Monetary Theory, inflation could easily and quickly emerge. Given the threat of inflation, real-assets (e.g., land, real-estate and commodities) may prove beneficial to portfolios. Moreover, precious metals, like gold, have generally performed well during periods of debasement in fiat money as we’re experiencing now. 

In summary, all eyes will be on the federal government in 2021. If policies remain highly accommodative, one may expect continued growth in risk assets like equities and inflation-hedges like commodities. However, any tightening or deflationary shocks, like the emergence of a new vaccine-resistant virus strain, could lead to significant pullbacks. 

End of Year Portfolio Adjustments

Now that the election is in our rearview mirror, it’s time to check our investment portfolios for any necessary end-of-year adjustments. The turbulence of 2020 will have a lasting impact on our lives and our portfolios so it’s important to proactively prepare for what may lie ahead. In this article I’ll describe some end-of-year strategies that you may want to consider.

First, let’s looks at the standard end-of-year tweaks. One tried and true investment practice is “rebalancing” (i.e., the practice of periodically buying or selling portfolio holdings based on performance). In other words, you reduce the investments that have appreciated the most and buy investments that have underperformed. For 2020, it’s been a wild ride but both U.S. stock and global bond portfolios have generally risen year-to-date. Interest rate reductions drove bond investments higher while low rates plus government income subsidies are generally listed as the reasons for the equity market surge following the March meltdown. In general, 2020 market performance has been driven by “mega cap technology”, while some smaller capitalization asset classes along with “Value” asset classes have lagged.

Another classic year-end adjustment would be to offset any capital gains with capital losses. When you buy and sell investments you generate a capital gain or capital loss based on the price change from when you purchased the investment. If you finish a year with a positive capital gain from the trades in your portfolio, you will generally pay taxes on the gain. Tax rates vary by income and holding period but can be as high as your income tax rate. As such, many investors seek to make year-end adjustments to mitigate this tax burden. The classic strategy is to sell some of your investments that have depreciated since the purchase date. Losses can generally be used to offset gains thereby reducing your current year tax burden. Please note that trades must be completed by 12/31 to realize this benefit. It is important to note that, for 30 days following a sale, you may not re-purchase an investment or the trade will be considered a “wash sale” by the IRS and the loss will be disallowed.

Aside from the standard end-of-year adjustments, the question remains about how to position portfolios for 2021. It’s hard to remember a time where it is more difficult to predict where things are headed. This brings us to another classic investment concept (i.e., diversification). Strong portfolios are created with investments that provide income and/or capital appreciation but have different performance in varying market conditions. The lack of correlation among investments helps to lower overall investment volatility and thereby improve performance. I’ll discuss a few ideas below for improving your portfolio’s diversification heading into 2021.

First, given the ongoing battle with the COVID-19 pandemic, there is a high likelihood that another relief package will get approved. The timing remains unknown but many believe more government assistance is coming. Although it will not be a stated intention of any relief package, it is well documented that past injections of liquidity  have contributed to asset price inflation including the stock market. Second, it is likely the Senate will remain in Republican control and therefore we will have a “divided” government. Without Democratic control, it will be harder for President Elect Biden to get all of his policy proposals passed which include increasing the tax rate on capital gains and corporations – both of which would be viewed unfavorably by the stock market. Third, the Fed has given strong guidance that they will keep the Fed Funds rate at or near 0% for an extended period of time – a huge benefit to public companies.

Still, with rates near 0% and low inflation, it is a precarious set-up for the bond market.  If rates or inflation ever begin to rise, it would be adverse to bond prices. While inflation isn’t likely to be an immediate problem given the deflationary impact from COVID-19, it could pick up in 2021. We’re seeing some factors that could contribute to inflation down the road including the following: a rapidly growing money supply, an increased willingness to provide direct cash payments to individuals that are not offset by higher taxes, improving growth prospects in emerging markets and a general trend toward anti-globalization (i.e., a desire to see more local production in place of lower-cost overseas production). Given the potential for inflation, investors may consider rebalancing into some assets that would likely appreciate in an inflationary environment. Commodities, precious metals, real-estate and other “real” assets, like timber or farmland, are all generally good hedges for inflation. Moreover, historically, home prices have outpaced the inflation rate so owning a home can also help to hedge your overall portfolio from a surge of inflation.

In summary, it’s impossible to predict the future so our portfolios have to be prepared for multiple potential outcomes. Diversification and rebalancing are as important as ever given the rapidly changing environment and increased volatility

Understanding the Volatility IndeX (VIX)

*Thanks to my good friend and former colleague, Eric Newman, for contributing this article. Eric spent the majority of his career as the Chief Investment Officer at TFS Capital, where he served as co-Portfolio Manager. Eric helped develop and oversaw one of the firm's proprietary trading strategies focused on volatility (VIX).

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Everywhere you look, financial commentators love talking about the VIX Index. If you believe what you read, this index seems to have the power to predict the future. It’s very often called a “fear gauge.” It can be a “red flag for the markets.” And apparently it can also be just plain “eerie.” But what is the VIX? And why is everyone so fascinated by it?

Let’s start with the basics. The VIX (or Volatility IndeX) measures how expensive “option” prices are. But what are options and why do we care how expensive they are? Options are simply the right to buy or sell shares of a given stock or stock market index. Imagine someone coming up to you and saying, “Hey, I’ll sell you an “option” to buy Amazon stock at the exact level it’s trading at today. And, you can exercise that right (that option) at any time in the next six months or not exercise it at all. Sounds pretty good, right? 

Yes, options have great benefits. In this case, your option ensures that you participate in any upside movement in the price of Amazon stock but don’t participate if it goes down. Suppose you wanted to own Amazon stock, but you are worried that a big decline is coming. If the decline happens, the stock will end up much lower than it is today. Owning an option, rather than the stock itself, allows you to risk less capital while still participating in the gains of the stock. If Amazon goes up, you get the gain, but if it goes down, you only lose the price of the option. 

So, what’s an option worth and why do we care?

The real, yet unhelpful, answer is that the option is worth whatever people will pay for it. That’s how the option market works. There are some obvious factors that will make the price higher or lower. For example, people are willing to pay more for an option that they can use over a longer period of time (e.g., one that can be exercised at any time in the next 2 years as compared to one that expires after just 2 weeks).

A second major factor affecting the price of options is the volatility of the stock or stock market index. In other words, if the price of a stock generally fluctuates a great deal, the option would be priced higher relative to a stock that is more stable. When it comes to pricing options, it’s not the actual volatility that matters but, rather, it’s the implied (or predicted) volatility. Not surprisingly, predicted volatility is constantly changing. 

At the beginning of this article, you were offered the option to buy Amazon stock at its current price. But there are also options that give you the right to SELL at today’s price. These are called “put options,” and they give you the right (but not the obligation) to sell at a set price over a set period of time (options to buy a security are called “call options”). If the stock crashes, you can use the put option to sell at the option’s fixed (and higher) price thereby avoiding a loss.

 This brings us back to the VIX Index. We mentioned above that the VIX measures how expensive options are. Its title as a Fear Index refers to people’s willingness to pay high prices for “put options.” In short, as investors predict or observe volatility, the VIX Index rises. Fear makes you willing to pay up for the safety of a put option.  

Investors generally expect the highest volatility following a stock market crash. It’s at this time that the VIX index soars. But in a calmly rising bull market, the VIX is generally very low. Take a look at some actual recent data; in particular, take a look at how the VIX skyrocketed while the S&P 500 Index fell in February and March of 2020:

Why does the VIX spike when the market goes down? When the market is crashing, people are afraid and they generally assume more volatility is coming. And that fear makes them willing to pay a lot more for put option protection.

Commentators and investors love to speculate about the direction of the VIX index. Headlines scream things like “The VIX could be getting ready to spike” which is a roundabout way of predicting the market will fall. Often the VIX begins to rise ahead of a market pull-back and, consequently, a rising VIX leads commentators to conclude that “investors are getting nervous.”

The VIX index is a fun and interesting number to track. Maybe it can show you the “fear” in the market, or maybe not. In either case, we hope you’re now better prepared to join the discussion.

2020 3rd Quarter Update

Top Headline for Q3: “Winners” and “Losers” Continue to Separate

Unfortunately, the COVID-19 pandemic remains with us and continues to affect nearly every aspect of our lives. This includes the financial markets where the most obvious impact is the dispersion of results in the US equity market. There have been clear “winners” with over 25 companies now up more than 400% for the year – a cluster of success that we haven’t seen in twenty years. This group includes Zoom, the most obvious pandemic success story, that has become a household name. On the flip side the pandemic has had a massive adverse impact on certain industries. The most obvious of these is the energy sector where the economic lock-down and reduction in travel has crushed the global demand for oil. To highlight the overall separation, the technology sector (ticker: XLK) is up 28.6% on the year while the energy sector (ticker: XLE) is down 47.5% through Q3. We can’t recall ever seeing such a pronounced gap in sector performance. The market dynamics are contributing to social unrest related to economic inequality as we are seeing a surge in new tech-entrepreneur billionaires at the same time that unemployment is spiking in traditional industries.      

General Market Update

US Equities:  The S&P 500 Index finished up 8.5% for the quarter while the technology-heavy Nasdaq Composite continues its year-to-date outperformance by rising 11%. The Russell 2000 Index finished up 4.6% and continues to substantially lag the larger-capitalization indices. As mentioned above, there were substantial differences in equity sector performance during the quarter. As we recently highlighted in a blog post from early August (Midsummer…..), the S&P 500 and Nasdaq Composite are up for the year but there has been very little “breadth” in this market surge. A lack of market breadth means that the stock market is being carried higher by a minority of high-performing companies.  It is generally not a sign of market strength. As mentioned above, the year-to-date rally has happened mainly on the back of one sector (i.e., Technology) and more specifically on the back of “Megacaps” like the “FANGMAN” group (i.e., Facebook, Amazon, Netflix, Google, Microsoft, Apple and Nvidia) – now collectively worth more than $7 trillion dollars. To further highlight how much these mega cap companies are driving market performance you can compare performance of the S&P 500 Index, which is “market cap weighted” to its “equal weighted” counterpart (ticker: RSP). The S&P 500 Index gives greater influence to larger companies mentioned above while the equal weighted holding RSP gives every company in the index the same weighting. Through Q3 the S&P Index is up 4.1% YTD while RSP is -5.3%.

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 5.5% in Q2 and the Schwab Emerging Markets ETF was up 9.9%. The developed international market continues to lag the US mainly on account of the industry composition of the European market (i.e., it has a lower percentage of technology companies). This allocation also helps to explain why these markets trade at much lower earnings multiples relative to the US at the moment. Emerging markets are starting to see a surge as economies continue to re-open, leading to a sharp rebound in manufacturing and trade.     

Fixed Income and Credit: The bond market has entered a new dimension of unprecedented price stability. The “MOVE Index,” which measures volatility in Treasury Bonds, is sitting at all-time low levels as bond prices trend sideways. The Federal Reserve entered these markets by buying corporate bonds and ETFs during the year to encourage price stability, and it worked. Corporate bonds would normally be selling off in a recessionary time but we’re seeing very little downside price movement as investors perceive the Federal Reserve as a “backstop” against price declines. Moreover, the Federal Reserve is driving the market in treasury securities where it has become, by far, the largest purchaser. This market is largely in the hands of the Federal Reserve at this point. If one believes they will continue to support it, price stability will likely remain. Without government intervention, we’d likely see a pull-back in prices as rising bankruptcies and the threat of inflation, combined with no room for further interest rate decreases, creates downside risk.  

A Look Ahead

The US stock market performance continues to surprise to the upside. There are some reasons for concern including (1) valuations are high, (2) the market is riding to new highs with very low market breadth, (3) technology is leading the market high and can be highly volatile, (4) the adverse economic impact from COVID continues with no clear end date and (5) we will enter 2021 with high economic-policy uncertainty given the ongoing social unrest. On the positive side, we are likely to continue to see a massive amount of ongoing government support in the way of direct subsidies to individuals and a continued zero interest rate policy (“ZIRP”). We continue to believe that the biggest winners of ZIRP and the Federal Reserve’s intervention are public corporations. With interest rates near zero, combined with the Federal Reserve’s direct purchases of corporate bonds, the cost-of-capital is at record lows. Not surprisingly, corporations are making 2020 a record year for bond issuance and are locking in rates for the long-term. The large-cap group looks to be the best positioned as companies like Amazon, Microsoft and Apple are able to issue bonds at rates that are barely above US Treasuries. They’re likely to resume share buy-backs with this money as soon as economic stability appears – a huge driver of shareholder return in recent years. It’s also noteworthy that the stimulus checks and PPP actually increased personal income during Q2 and would do so again when/if further rounds are approved. This likely helps corporations in the short run but may lead to inflation over time. To say the least, it’s a tricky time for projections – especially when the government has taken such an active role in affecting outcomes. 

With the upcoming Presidential election and headlines regarding ongoing additional stimulus negotiations, the stock market will likely see increased volatility. Historically speaking, the market hasn’t liked uncertainty. Not knowing who the next President will be will likely influence short-term market moves more than who actually wins the election.

On the bond side, it would seem that we’re in a position where all the risk is to the downside (i.e., rates are not likely to go any lower and inflation is only likely to go higher – neither of which would be good for bonds). So, why are prices not trending lower? For one, the Federal Reserve has indicated that ZIRP is here to stay for a while so investors are not perceiving much interest-rate risk. Moreover, the Federal Reserve is in full price-manipulation mode in this market. As the primary buyer of US Treasuries, they can likely control price. This has been done in other countries (e.g.,  Japan) as a form of stimulus and is known as “yield curve control.” And, the direct purchase of corporate bonds has curbed any selling.  Giving the Federal Reserve’s willingness to provide a virtual “blank check” to create stability in these markets, near-term stability is probably a good bet. Still, bonds are not likely to provide substantial overall yield going forward. Rather, a small dividend with stable price is likely where we’ll stay for the foreseeable future. Of course, any stock market panic could drive treasuries higher as we’ve seen in the past.

One interesting dynamic at work right now in the marketplace is the tension between inflationary and deflationary pressures. Recessions are inherently deflationary as are productivity enhancements driven by technology. Moreover, demographics (i.e., the aging “baby boomer” population) is driving less economic demand in the US as we’ve seen play out in “aging” countries like Japan. Deflation is generally considered bad for an economy because it discourages investment and spending (i.e., participants prefer to wait until prices are lower). Given this dynamic, the Federal Reserve, like most central banks, has a target inflation goal of 2%. Moreover, they’ve recently stated that the goal is to “average” 2% and intend to let inflation run above 2% to achieve that goal. The effective “money printing” by the government by issuing Treasury bonds that are then bought by the Federal Reserve can contribute to inflation as economic activity picks up. And, it can happen quickly. We’ve seen this occur historically in the US around World War II and also during the 1970s to the early 1980s. Given the threat of inflation, real-assets (e.g., land, real-estate, commodities and precious metals) become a more interesting investment. We plan to continue to monitor the inflation dynamic and will consider additional allocations to these types of investments.     

Stay safe and, as always, feel free to reach out if you have any questions or if we can help with anything.

Gold Rush 2020

We are all familiar with traditional stock and bond investments as they provide the nucleus for most of our investment portfolios.  However, we often neglect other “alternative” investments that can provide key types of exposure during challenging investment periods.  Gold, and other precious metals, is one such investment category that can act as a hedge against inflation and provide a safe haven in times of crisis.  At Patina Wealth, we actively look for opportunities to deploy precious metals in portfolios and have added to the category in 2020 for most investors.  We generally prefer using Gold over other precious metals as the former generally has lower price volatility.

So far in 2020, gold and silver have surged and now stand among the top performing investments year to date.  From December 31st through August 31st, the exchange-traded-funds tracking gold and silver (GLD and SLV) are up 29.3% and 57.3% versus 8.3% for the S&P 500 Index and 6.8% for the aggregate bond market (as measured by AGG).  It’s also noteworthy that precious metals tend to not be highly correlated with either stocks or bonds meaning they can enhance the risk-adjusted performance of portfolios.

Precious metals are part of an investment category known as commodities.  Commodities generally refer to raw materials or agricultural products.  The price of commodities, like most assets, is determined by supply and demand.  When the price of a commodity is trending in a particular direction, it usually means there is an imbalance in supply and demand.  So far in 2020, there has been a massive surge in demand for precious metals.  Let’s explore why this imbalance has existed and where it may be headed from here.

Precious metals have a commercial use, however, this has had very little to do with the recent price surge.  Rather, investors are piling into the category as a form of defense against the uncertainty of the current investment landscape.  In general, precious metals prove to be great investments when certain conditions are present.  These conditions include, (a) periods of high inflation, (b) an environment of socio-economic or currency instability and/or (c) negative “real” interest rates (i.e., interest rates net of inflation). 

Currently, we have two of the above conditions present (i.e., negative real interest rates and currency instability).  Moreover, while inflation is not currently present, many economists believe that we are headed for an inflationary period in the coming years given that central banks are aggressively seeking to kick-start economic activity with very accommodative policies which are inherently inflationary.  It’s also noteworthy that the Federal Reserve targets 2% inflation, on average, as a matter of policy and has said they are comfortable letting it run above that target level in the near term.  Still, targeting inflation and achieving it are two different things and many developed nations (e.g., Japan) have generally failed to achieve their inflation targets for over a decade. 

Regarding the conditions that are present, let’s first look at negative real interest rates.  Real interest rates are negative when the rate of inflation exceeds the rate of interest paid on a given fixed-income investment.  Presently, it is estimated that over $15 trillion in bonds globally are paying a negative real interest rate (i.e., net of inflation, allocating money to these bonds would effectively cause your wealth to shrink over time).  It’s noteworthy that we have never had such a high percentage of the global bond market effectively losing money net of inflation.  In such an environment, gold becomes an attractive alternative to bonds because it is perceived to move more in line with inflation which, even if low, is perceived to be above zero.  What is further fueling investors is the fact that central banks of developed nations are providing guidance that they have no intention of raising interest rates anytime soon and are aggressively looking to increase inflation.  In other words, they are clearly and emphatically signaling that negative real rates are not likely to go away for a long time and, in fact, are likely to worsen. 

Gold is also perceived as a potential remedy to currency instability.  The amount of gold at any point in time is generally fixed.  More can be mined but this doesn’t happen quickly.  Currency, on the other hand, can be printed by central banks and can change dramatically from year to year.  In fact, in 2020, we’ve seen a massive increase in the money supply in the United States and other developed countries.  This is a further tailwind to gold as the dollar price of gold stands to gain as more “fiat” (i.e., paper) currency is created.  Moreover, as fears are stoked about the credibility of a currency investors can pile into gold as a form of shelter.  Although we’re a long way from destroying the credibility of the American dollar, the rampant money printing globally is causing uncertainly and contributing to gold demand.

As we look to the future, one would expect some pull-back in the prices of precious metals.  The prices have risen so far and so fast that some consolidation would be expected.  However, the medium to long-term case for precious metals, and for gold in particular, remains bullish.  Regarding the money printing by central banks, it’s hard to see an end in sight.  COVID-19 has caused substantial unemployment and central banks are aggressively providing support which is dramatically increasing the money supply.  Moreover, things are likely to get more accommodative from here.  For example, any prolonged economic downturn is going to mean a prolonged period of government assistance.  Moreover, in the mid to long-term it’s hard to see how all of our “unfunded” obligations like social security and state pensions are going to be met without further money printing.  Perhaps the strongest argument for a continued rise in gold demand is the expected real interest rate forecast.  It’s tough to find an economist who thinks we’re going to see positive real rates in the next few years.  Gold feels like a good bet because centrals banks, like the US Federal Reserve, have indicated that they intend to keep short-term rates at zero and target inflation at 2%.  In other words, their goal for the foreseeable future is to target -2% real short-term interest rates which would keep the vast majority of the bond market in negative territory.  As always, we will continue to monitor the situation and look to make adjustments as more information becomes available.

Midsummer Thoughts and Observations

While the pandemic has prevented face-to-face meetings, communicating with clients in other ways has become more important than ever. There are some very interesting things happening in the market right now and I wanted to share some thoughts and observations with you. 

It seems like just yesterday the stock market was plunging at a record pace. From February 19th through March 23rd, the S&P 500 Index dropped a whopping 35.4%. Since then, the S&P 500 has *almost recaptured its losses and as of July 31st, was within 4% of its intra-day all-time high set in mid-February. 

However, the rebound of the S&P 500 Index doesn’t tell the whole story though. While the S&P 500 Index has long been seen as a broad market barometer to gauge how the overall stock market is performing, it may not be as good of an indicator as it once was. The S&P 500 is “market cap weighted,” meaning companies in the Index who are larger represent a bigger part of the Index. For example, the top 5 positions in the Index as of July 31st (as represented by the ETF “SPY”) were Apple, Microsoft, Amazon, Google and Facebook. These 5 companies represent a whopping 21.55% (!!!) of the Index. That’s not a whole lot of diversification. The other 501 companies (the ETF actually holds 506 stocks), represents the other 78.45%. In fact, the smallest 19 companies in the S&P 500 Index (according to SPY) each represent 0.01% or less.

These mega cap technology companies have driven the S&P 500 Index’s performance so far this year into slightly positive territory. SPY is +2.52% YTD through July 31st. But, the S&P 500 “equal weighted” ETF, ticker: RSP, is -6.35% through July 31st. So, if every company in the S&P 500 had an equal weight in the Index and you ignored the size of the company, the Index is actually negative YTD. This is a great illustration showing just how much those mega cap technology companies are holding up the market. Another interesting data point is the Russell 2000’s YTD performance. This index represents 2000 small cap companies and is underperforming the broader market even more so far this year. The ticker IWM, iShares Russell 2000 ETF, is -10.42% YTD through July 31st.

Separately, there has been a distinct divergence between “Growth” companies and “Value” companies through July 31st. Schwab’s Large Cap Growth ETF, SCHG, is +18.19% YTD while its Value counterpart, Schwab Large Cap Value, is -12.29%. Technology’s YTD dominance has also played a part in this as the top holdings in SCHG are, you guessed it, Apple, Microsoft, Amazon, Facebook and Google. This is a great example of why we hold a separate Value and Growth position in most client portfolios. Such divergence creates rebalancing opportunities.

While the S&P 500’s performance has been rosy lately, there are some troubling signs in other areas of the market. Often seen as a safe haven, Gold closed at a record high on Friday, July 31st, and crossed $2000/ounce for the first time in its history. As the Fed has pumped the system with liquidity, Gold has benefited as it is often viewed as a protection from inflation. Many clients’ portfolios have benefited this year from the addition of Gold through the ticker GLD.

Also, the 10-year Treasury note had a record low close on Friday, July 31st, of 0.5282%. It did, however, have a lower “intra-day” low back on March 9th when it hit 0.39%. But, even going back to the financial crisis of 2008, it never closed the day as low as it did on Friday. Lower bond yields generally signal trepidation over the U.S. economy’s health.

The stock market surge from the recent market bottom in March seems like a different story than what the economy and recent COVID-19 cases are telling us. The unemployment numbers continue to be high and recent economy reopening setbacks are raising some red flags. While we don’t think investors should attempt to time the peaks and valleys of the market, we have slightly increased cash and fixed income positions in an effort to manage portfolio volatility.

If I can answer any questions, please don’t hesitate to reach out.

2020 2nd Quarter Update

Top Headline for Q2: Stimulus Wins Round 1

Unfortunately, Q2 ended much as it began with the COVID-19 pandemic disrupting our lives in unprecedented ways.  Our thoughts continue to go out to all those families directly affected and the many healthcare professionals who are risking their lives each day to support them.    

As we reflect on the market performance for the quarter, it’s hard not to be somewhat in awe of the resiliency of the market, given the economic backdrop.  The equity market “bounced” off the lows and saw one of its best quarters ever.  While the S&P 500 Index did not quite fully recover its drawdown, the Nasdaq Composite now sits at an all-time high.  The surge was led primarily by its largest constituents (Amazon, Apple, Microsoft) each regaining an all-time high during the quarter and each finishing with a market capitalization near $1.5 trillion. There were clear sector winners and losers with certain technology sectors booming amid the “stay at home” requirements while others like energy and real-estate struggled to gain footing.  What is most shocking about the overall rebound is that there has been very little good news.  For example, during Q2 companies adjusted earnings down 37% (the highest drop ever recorded by Factset), some jobs returned but the news is still bad as Refinitiv reports that we’ve recovered less than ¼ of the lost jobs and July 1 marked the largest number of new COVID-19 cases (over 50,000) since the crisis began.  So, why does the US equity market not seem to care about the negative news?  The two most common explanations are (1) that the market is reacting favorably to the stimulus and looking at earnings 2-3 years out, and (2) that some of the excess capital from the stimulus is finding its way into the equity market. 

General Market Update

US Equities:  The S&P 500 Index finished up 20% for the quarter while the technology-heavy Nasdaq Composite surged 30.6%.  The Russell 2000 Index finished up 25%, but, after falling more than 30% in Q1, it continues to substantially lag the larger-capitalization indices.  There were substantial differences in equity sector performance during the quarter as the market attempted to assess “winners” and “losers” from the crisis.  The tech sector (measured by the ETF XLK) surged during the quarter and finished up about 15% year-to-date whereas a few of the big losers included energy (XLE) which is now down over 35% year-to-date and financials (XLF) which is down nearly 24%.  Certain sectors of the REIT market continue to struggle, including retail and hospitality, with over 50 companies already slashing dividends to improve cash flows.  The equity market is a bit of a paradox right now as it has been awhile since we’ve seen such a disconnect between market valuations and the present economic realities.

International and Emerging Market Equities:  International equity markets continue to lag US markets.  Not only did they fall further during Q1 but they recovered less in Q2.  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 16.0% in Q2 and the Schwab Emerging Markets ETF was up 18.2%.  International markets continue to trade at much lower earnings multiples relative to the US. 

Fixed Income and Credit: The economic fear hitting the equity markets also appeared in bonds where rampant selling led to substantial drawdowns in corporate bonds.  However, the “bounce” in this segment was even more dramatic.  As the government stepped in to buy corporate bonds, money flooded back into the market where suddenly yields seemed high and risk low.  The long-term corporate bond market crashed about 30% but has nearly fully recovered.  This market also leaves one perplexed as the economics are not good for many highly-leveraged corporations.  Bankruptcies are rising along with bond downgrades but both are being overshadowed by the perception that the government with continue to support corporates.  Treasury bonds have also performed well with the massive tailwinds of falling interest rates, economic uncertainty and government buying.

A Look Ahead

In our opinion, it has never been harder to assess the near term direction of the equity market.  There are many factors that point to “bubble-like” conditions (e.g., the US market is at an extreme valuation relative to foreign markets, the US market is squarely in the “high” range of almost any valuation metric and economic conditions are horrendous).  However, we’re dealing with a level of stimulus that is truly unprecedented.  No one benefits more than large corporations from a zero interest rate policy and we’ve seen a surge in bond issuance as corporations have taken the opportunity to lock in low rates and extend due dates.  This refinancing will improve margins for the survivors coming out of the downturn and the large-cap group looks to be the best positioned.  It’s also noteworthy that the stimulus checks actually increased personal income during Q2, despite the record unemployment, so we don’t have a clear picture of the impacts.  Moreover, we don’t know what additional stimulus may be coming and how long it will last.  It’s hard to imagine a time when our economy and equity markets were not more closely linked to the actions of our federal government. 

To compound the forecasting problem, we are dealing with a number of large unknowns.  The biggest, of course, is the ongoing pandemic.  Cases are still rising but we’re getting better at mitigation techniques and treatment methods.  Moreover, many companies are at work on vaccines.  Still, the near-term direction of the crisis in the US couldn’t be more unclear.  The second massive unknown is the upcoming November presidential election.  Aside from not knowing the winner, we can only guess about the policies that will take priority as the election approaches.  Will social issues be the focus or, for example, will tax reform move to the forefront?  The recent tax cuts have benefitted corporations, and any reversal will certainly have an adverse impact.  Lastly, the massive stimulus has led to an enormous growth in our money supply.  This is an experiment without precedent, and economists can’t seem to agree on the inflation impacts or when they’re likely to hit.     

In closing, it’s hard to not comment on the “moral hazard” aspect of the stimulus and its unknown impact on our capital markets.  In 2008, there was, appropriately, significant debate about having the government step in to “rescue” companies deemed “too big to fail.”  During this crisis, there was little debate or delay before supporting a wide swath of corporations through bond buying.  Some of these companies are “zombies” (i.e., negative cash flow companies) that perhaps shouldn’t survive and, in fact, should be absorbed by companies that are more productive with capital.  The current talk is now around the possible direct purchase of equities.  The general perception right now seems to be that the US government is protecting corporations and it’s driving up equity and bond prices.  In other words, it’s at least partially artificial which will likely lead to further volatility in the future when perception changes.  While we’re supportive of intervening to a certain extent during a crisis, one is left to wonder how to get this genie back in the bottle without a massive market disruption.

COVID-19: Current Economic Climate

After studying the economic data over the last few weeks, unprecedented is a word that often comes to mind.  The most striking example of the unprecedented economic impacts from COVID-19 appears in the employment data.  In a span of merely six weeks, we have seen over thirty million people in the United States file for unemployment.  That total equates to roughly one in five American workers – a staggering total.  As we can see from the chart below (courtesy of the Wall Street Journal), the claims are slowing but we saw over three million in the last week and will likely see many millions more before returning to more normal levels.

To put these job losses in context, let’s compare the job losses to the “Great Recession.”  If we look at chart below showing “Continuing Jobless Claims” (i.e., folks that haven’t landed a job and continue to file state unemployment claims),  we can see that we’re already at levels about three times higher than what we saw following 2008 and it’s still projected to get worse.  So, in summary, you’d have to return to our worst economic collapse ever (i.e., the “Great Depression”) to find numbers like this.

On the bright side, unlike the Great Depression, there is reason to believe that many of these job losses will be reversed quickly as businesses are hoping to quickly ramp back up following the pandemic.  Many “unemployed” workers are, in fact, “furloughed” (i.e., still employed, often with benefits, but not being paid) and are fully expecting to return to their prior employer in the coming months.  Social distancing measures have been effective in slowing the growth of the virus and there is reason for optimism that more businesses will begin to open – albeit with some revised standard operating procedures.  It’s also been impressive to see American ingenuity at work as many businesses have reinvented themselves quickly during the crisis (e.g., restaurants ramping up take-out operations and “gig economy” delivery apps like Instacart and DoorDash becoming household names).  We’ve also been impressed with the speed at which schools have moved to virtual learning platforms and healthcare has adopted telemedicine.  It’s clear that we will emerge from this pandemic in much better shape to combat future outbreaks with less disruption.

It is a little scary, however, that the American economy, like many in the developed world, has steadily become more and more service-oriented.  The U.S. Bureau of Labor Statistics, for example, indicates that we now have about ten million workers each in education and health care, over seven million in personal care and over thirteen million in food preparation and serving related.  This shift is normal and consistent with other developed nations.  Productivity gains simply allow us to meet basic needs with fewer workers.  For example, the New York Times reports that over 30% of U.S. workers were in farming/agricultural in 1920 (the first year of the Census) compared to less than 3% today.  It’s also noteworthy that less than 15% of our workforce are in manufacturing.  While we believe this shift is an encouraging advancement (e.g., basic needs are able to be met by fewer workers leading to lower costs and higher standards of living), it does show the fragility of our current service-based economy.  The reality is that many service-related jobs are considered “non-essential” and inevitably more vulnerable to short-term impairment or permanent elimination. 

The additional danger of the current situation, is that it can become a negative cycle that feeds on itself.  The American economy is driven first and foremost by consumer spending.  Americans that don’t have jobs simply don’t have the discretionary income to spend.  Moreover, even employed Americans become cautious as uncertainty spreads.  We are seeing this caution manifest immediately as a massive spike in the “savings rate” (i.e., the percentage of disposable income that is set aside for savings).  The savings rate nearly doubled in the last month to over twelve and one-half percent – the highest rate seen in thirty years.  A high savings rate can be scary for businesses that become reluctant to invest and/or hire thereby perpetuating the cycle.

As we mentioned in our quarterly update, the unprecedented challenges presented by COVID-19 have been met by massive stimulus by central banks around the world.  The news has been well-received by the stock and bond markets which have rapidly recovered much of the drawdown.  At this point, it’s impossible to know how this situation will play out from here as many companies have “pulled their guidance” for the remainder of the year. In other words, it is hard for them to predict short-term future earnings.  If consumers and businesses continue to gain confidence that the worst is behind us, we may see a rapid rise of employment and a return to pre-Pandemic consumer spending levels.  The outlook may be even brighter on the business spending side where investment may exceed pre-Pandemic levels given the return to a zero-interest-rate environment.  However, if uncertainty remains and caution persists, we could see many jobs losses become permanent.  A resurgence in positive COVID-19 cases or a delay in the development of a vaccine would be potentially devastating – an outcome that would lead to a much more prolonged downturn and likely further stimulus.  In either scenario, in our view, it’s likely that more short-term volatility will persist as markets rapidly try to digest each new wave of data.  Of course, we plan to continue to monitor the situation and will adjust plans accordingly.  If we can be of any assistance during this difficult time, please don’t hesitate to reach out.