When the Fed convened last month and previewed its rate policy for the remainder of 2024, no one anxiously called to inquire about changing their investment allocation. The same can be said when Apple and Nvidia reported quarterly earnings earlier this year. Or when March CPI and 4th quarter GDP data were released. And yet, when the presidential election result becomes clear – likely sometime on the morning of November 6 and regardless of who the winner is – I anticipate getting an anxious email and/or phone call with concern about the impact to investment markets and to inquire about whether we should make any portfolio adjustments. This is not meant to suggest such natural anxiety or emotional reaction to an election result is unhealthy. Our minds behave how they behave and that is just a natural response.

Despite this anticipatory anxiety, it is fundamental to understand that elections have a far, far, far less significant impact on investment markets than most tend to believe. This common overreaction can largely be attributed to the intense media coverage and discussion elections receive, which amplifies our emotional responses and can distort our perception of their actual importance to financial markets. Elections bring drama and competition – both of which attract viewers, readers, and listeners. Media coverage of any topic is always driven by economic incentives. High interest in presidential elections and a national audience translates to increased viewership and readership which boosts advertising revenue for media outlets. That said, it benefits financial news media to connect presidential elections to financial markets – even if robust data demonstrates that the actual connection is very limited.

The fact is this: historical data and numerous empirical studies demonstrate that the long-term influence of elections on market direction and economic fundamentals is minimal. The forces that truly drive market performance—such as economic growth rates, interest rates set by central banks (like the Federal Reserve), corporate earnings, and global economic policies—tend to have a much stronger and enduring impact. Therefore, the heightened emotional response to election results is more a reflection of our susceptibility to media narratives and less about the substantive influence of these events on the investment landscape.

That said, I want to also address a few of the other fictional narratives around elections that will be useful to keep in mind as November approaches.

Fiction: Election years are more volatile than average.

Investors tend to equate election years with elevated uncertainty. As a result, some might wait until after an election to invest under the illusion that the election will bring greater clarity or stability.

There is no historic evidence that election years are more volatile than normal. In fact, presidential election years since 1890 have experienced less stock market volatility than non-election years as evidenced below.

Fiction: Once the election result is known, we should reduce/increase risk if Trump/Biden is elected. 

Once the election results are publicly known, stock and bond prices should immediately reflect the result, positive or negative.  In order to justify trading based on the result, we would need to have a better understanding of what the result means for global economics than the rest of the world or we would simply need to know the election outcome before the rest of the world. 

Quoting from the Wall Street Journal, “Extrapolating common knowledge into predictions of the future is really just following the herd, and that typically doesn’t go well.” I cannot emphasize this enough: The market does not move based on what happens but on what happens that was not already expected to happen.

Fiction: Given the uncertainty surrounding the election, it’s a good idea to hold cash and wait until after the election to invest.

Since investment markets move higher over time, this line of thinking inherently presupposes that markets will perform poorly leading up to a presidential election and that the clarity of a winner will then lead markets higher. The truth is that the stock market has historically increased at a higher rate in the six months leading up to a presidential election than in the other 42 months of each 4-year cycle.  Uncertainty is always a risk but assuming risk is what you get compensated for as an investor. Avoiding uncertainty or risk may help you sleep better but it generally comes at a cost of lower returns.

Fiction: A Republican White House tends to be more business-friendly which is better for the stock market.

Against conventional wisdom and theory, the data shows that a Democratic president is better for the stock market and the economy. Since the S&P 500’s inception, the stock market has gained an average return of 48.3% during the 4-year terms of Democratic presidents versus 19.3% during terms of Republican presidents. Those figures are measured starting from Inauguration Day but if we change the measurement to start and end on the day after each presidential election, the data remains largely the same: 19.5% average returns for Republicans vs 46.8% vs Democrats.

The broadest measure of economic output – real GDP growth – paints a similar picture. On average since World War II, the economy has grown one percentage point faster under Democratic presidents. Republicans might argue that the greatest economic crises since World War II – the global financial crisis (GFC) of 2008 and the Covid crisis of 2020 – both occurred under Republican presidents and skew the results. However, such an argument falls flat – the gap in real GDP growth between the parties was even wider prior to 2008.

Does this data mean that a Democratic presidential victory in November will be better for the stock market? Certainly not.

It bears repeating that the person in the White House matters much less to the stock market than is perceived. The stock market is NOT a measure of employment growth or GDP growth or border security or abortion policy or government social spending. Over extended periods, the growth of the stock market is determined by how much money Apple and Amazon and Ford and Caterpillar and Exxon and Microsoft and Pfizer make. The profits that companies make will be what drives the stock market up or down – not the domestic and foreign policy agenda of a president.

Fiction: Specific sectors are likely to perform better under a Republican president or Democratic president.

Upon Donald Trump’s election victory against Hillary Clinton in November 2016, market prognosticators were consistent in their view of the sector most likely to benefit from a Trump presidency: Energy. Trump campaigned on allowing more federal land oil and gas drilling, easing environmental regulations on coal companies and fracking, restoring pipline projects including the critical Keystone pipeline, and generally creating a favorable environment for energy companies.

What happened over the following four years of the Trump presidency? The energy sector was an investment disaster – ranking dead last of all sectors by an enormous margin. $1,000 invested in the energy sector at the start of Trump’s presidency became $611 at the end – an annualized loss of 11.6% per year.

Conversely, no forecasters suggested that Biden’s presidential victory in 2020 was going to be a positive jolt for the energy sector. Biden campaigned on rejoining the Paris Agreement, dramatically reduced fracking, and immediately restricting oil and gas drilling. Wall Street sentiment for the energy sector after Biden’s win was somewhere between negative and sell-all-your-oil-and-gas-stocks negative. And yet over the course of the Biden presidency to date, the S&P energy sector – which is comprised almost exclusively by traditional oil and gas companies – has been the best performing sector, doubling the performance of its closest competitor.

Furthermore, consider the other leading beneficiary of Trump’s 2016 victory – the defense industry. Trump campaigned on increasing the size of the military, modernizing the nuclear arsenal, and expanding defense spending. Making matters more favorable for defense companies was that Republicans also won House and Senate majorities in the 2016 election. Defense stocks jumped on the day following the election and Forbes published an article that day titled “For the Defense Industry, Trump’s Win Means Happy Days are Here Again”.

Over the subsequent four years, the defense industry lagged the overall stock market by 44%.

Why are predictions about what stocks and sectors will perform best or worst after an election often so horribly wrong? For the same reasons that forecasters are lousy at predicting what the stock market will do over the next year. There are many external factors that are simply not predictable in advance which will have a dramatic impact on stock prices and the economy. Few, if any, predicted 9/11 or the severity of the Covid pandemic or the overnight collapse of Lehman Brothers and yet these events had dramatic impacts on stock prices. You might have predicted everything else perfectly but if you did not factor these externalities into your predictions of the future, your forecasts were horribly wrong. On this note, it was not Trump’s victory in 2016 and subsequent policies that caused energy stocks to plummet for the next four years – it was the unanticipated increase in global oil production that caused supply to dramatically outpace demand and energy prices to plunge.  

Presidential policy objectives will have some impact on industries and sectors. But these policies are 1) known in advance and priced into stocks; 2) often limited by checks and balances within our government such that presidents never achieve all their policy initiatives; and 3) often one small factor among a long list of far more important factors impacting stock prices.

The idea that an investor should favor industries or sectors based on an election result makes for a compelling story that Wall Street will again sell to millions of unsophisticated investors despite the fact that the track record of such advice is abysmal and will likely again be abysmal in the future.

Fiction: We should be concerned about dramatic changes to tax policy under a second term of President Biden or a reelected President Trump.

Here is the reality: Most provisions of the Tax Cuts and Jobs Act (TCJA – “Trump Tax Cuts”) are scheduled to sunset at the end of 2025. If Congress allows TCJA to sunset, the effect is a tax hike on most Americans. Neither party of Congress wants to be blamed for tax hikes and so the most likely outcome – regardless of which party controls Congress – is an extension of TCJA.

Does this change depending on who wins the White House in November? Probably not. Even though an extension of TCJA will add trillions to the deficit, both candidates have demonstrated indifference to deficits. Trump is already campaigning for “his tax cuts” to be extended and while Biden may aspire to only extend the tax cuts for taxpayers below a specific income level, he’s very unlikely to get such a measure passed without a Democratic majority in both the House and Senate.

The most likely outcome – regardless of who wins the presidency – is an extension of the existing tax law.

In Conclusion

While the anticipation of presidential elections can generate considerable anxiety and provoke inquiries about potential adjustments to investment portfolios, the impact of these political events on financial markets is significantly overstated. Historical data and empirical studies consistently demonstrate that the long-term influence of elections on market performance is minimal, with economic growth rates (which are not materially impacted by presidents), interest rates set by central banks, corporate earnings, and exogenous events playing far more pivotal roles. The narrative that elections bring about significant market volatility or that the outcome should dictate investment strategy is largely a myth perpetuated by media coverage seeking to capitalize on the drama for economic gain. Instead, investors are well served to maintain a long-term perspective, understanding that the stock market’s performance is driven by the profits of companies and not by the transient nature of political events. The evidence suggests that neither the party of the president nor the immediate aftermath of elections reliably predicts market movements, making it imperative for investors to resist the allure of speculative decision-making based on election outcomes.

John Kenneth Galbraith, the prominent economist and economic advisor to several presidents, once said that “the only function of economic forecasting is to make astrology look respectable.” His sentiment underscores the high unpredictability of economic outcomes and the tendency of the economy to do exactly the opposite of what most expect.

On the whole, the US economy has decidedly exceeded expectations in 2023. Such robust economic performance in light of weak expectations should not be surprising. This performance again underscores the dynamism of US businesses and consumers, proving their capacity to thrive even amidst global uncertainties.

Despite the headwind of tighter Federal Reserve policy and stricter lending standards following the collapses of Silicon Valley Bank and then Signature Bank in March, the unemployment rate has remained below 4% since the start of 2022. Furthermore, the labor force participation rate (age 25-54) is at its highest level in more than two decades suggesting that nearly everyone who wants a job, has a job. All the data tells a clear story about the labor market – that it remains very tight with plentiful jobs and a scarcity of workers.

The domestic economy grew by 2.2% in the first half of 2023 in real terms – above the level of inflation. Additionally, the GDPNow estimate – which accounts for a plethora of reported economic statistics – currently indicates GDP growth of 5.1% in the recently completed 3^rd quarter. Service-sector spending – which constitutes 78% of US GDP – has been the key engine of growth as consumers continue to aggressively spend on services.

The glass-half-empty crowd is never void of compelling risks or deteriorating segments of the economy and the current environment is no exception. Both the manufacturing and commercial real estate sectors, which are notably sensitive to interest rates, have been negatively impacted by the Federal Reserve’s significant rate increases. Pessimists can also point to headwinds such as the resumption of student loan payments which will crimp consumer spending, political dysfunction in DC, a looming government shutdown in November, and the threat of even higher energy prices as the Israel-Hamas war potentially chokes off shipping lanes.

What’s going on with the bond market?

Things have taken a turn for the strange when the typically uneventful bond market consistently overshadows stocks in headline news. Welcome to 2023.

Expectations were high at the beginning of the year that the prolonged downturn for bonds was concluding. Firstly, bond yields entered the new year at their highest levels in 15 years ensuring that investors would benefit nicely from regular coupon payments, even without capital appreciation. Secondly, economists and central bankers were in agreement that 2023 would bring an economic slowdown due to the Federal Reserve’s aggressive interest rate hikes. This widely anticipated slowdown would curtail inflation, leading to lower interest rates and subsequently higher bond prices.

Prior to 2022, the Bloomberg US Aggregate Bond Index had never experienced two consecutive calendar year losses and yet here we are – more than ¾ of the way through the year – with another negative sign preceding the bond index’s calendar-year return. Notably, it’s not an insurmountable deficit – The Bloomberg Aggregate Bond Index is down by 1.2% over the first nine months of the year – a gap that could certainly be reversed in the 4^th quarter if long-term rates just stop their upward ascent.

The silver lining is that as bond prices decline, expected future returns increase. Consider that the 10-year Treasury yield historically explains 91% of the return an investor realizes over the subsequent decade when holding a portfolio of intermediate-term high-grade bonds (to maturity and reinvesting coupons at the prevailing rate). You would be hard-pressed to find a better forecasting tool in capital markets than the current yield at forecasting future returns.

And to this point, the 10-year yield recently hit its highest level since 2007 driven by the aforementioned economic data which has consistently come in better than expected. The net result to investors (you) is that the expected return for bonds over the next decade is far more compelling now than at any point over the past 15-20 years.

The chart below demonstrates the historic increase in rates over the past three years. While the climb up has not been kind to bond prices, the now higher yields present a much more compelling environment for bond owners.

Additionally, this chart shows the dramatically higher yields provided today by bonds relative to the start of 2022.

Finally, it is worth noting that the prevailing view on Federal Reserve policy – which we can specifically calculate from the interest rate futures – is that the Fed will hold short-term rates steady through the middle of 2024 and then begin gradual rate cuts. Although an unexpectedly high inflation reading could change things, the market-implied probability of any additional rate hike this year or next is less than 30%. 

And what about the stock market?

I wrote last quarter about the “Skinny Bull” – a term used to describe how seven stocks referred to as the “Magnificent Seven” accounted for more than 100% of the S&P 500’s return in the first half of 2023. The market dominance of the Magnificent Seven (Microsoft, Apple, Alphabet, Amazon, Meta, Tesla, Nvidia) subsided in the third quarter but the spread between these megacap stocks and the rest of the market has been the dominant theme in the stock market this year.

The following chart shows the 2023 returns of three indices:

1. The S&P 50 – the 50 largest stocks in the S&P 500, weighted according to market size such that the Magnificent Seven constitute 49.8% of the index;
2. The S&P 500 Index – the widely cited index comprised of 500 stocks, each weighted according to its market size; and
3. The S&P 500 Equally Weighted Index – using the same 500 stocks but with each stock equally weighted at 0.2% of the index.

This chart tells the story of what has driven the stock market this year. The S&P 50 Index- with roughly half of its weight comprised by the Magnificent Seven – gained 27.9% in the first 9 months. Conversely, the Equal Weight S&P 500 – a better representation of the broad market where every stock represents 0.2% of the index regardless of the company’s size – posted a relatively meager gain of just 1.7%.

To be fair, the Magnificent Seven have all showcased resilient business models, compelling revenue growth, and excellent profit margins. The proliferation of technology and digitalization, coupled with their robust financial health, has enabled them to navigate through economic fluctuations. They are great companies. But we must remember the most fundamental concept of investing: Price matters. Investors, attracted by the seemingly steadfast growth of these market leaders, have lately abandoned valuation metrics for fashionable stories – buying great companies for their hype even if the valuations bake in outlandish future growth scenarios.

There is a valuable lesson from the founder/CEO of Sun Microsystems, Scott McNeely, speaking about his own company’s stock during the late innings of the dot-com bubble:

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

With the benefit of hindsight, investors now think of the 1999-2000 dot-com valuations as outrageously unsustainable. But consider that Tesla presently trades at 9.7 times revenues – roughly the same level that Scott McNeely described as ‘ridiculous’ when speaking about his own company’s stock. Or if you really want a poster child for the potentially unsustainable valuations of the current market, consider that Nvidia trades not at 10 times revenues or 20 times revenues but at 35 times revenues.

What about stocks relative to bonds?

With the dramatic rise in interest rates over the past three years making bonds more attractive and the rapid ascension of stocks over the past three years arguably making stocks less attractive, is there a case to be made for bonds relative to stocks?

There is a recent argument using a valuation tool known as “The Fed Model” that suggests bonds are attractive relative to stocks for the first time since the dot-com era (it should be noted that the Fed Model data was skewed for several months during the 2008-2009 Great Financial Crisis because of negative earnings for the stock market). The idea of the Fed Model is that we can evaluate the relative attractiveness of stocks and bonds by comparing the earnings yield of stocks (earnings divided by price, also the inverse of the P/E ratio) to the 10-year Treasury yield. This approach gained prominence and its name in the late 1990s when the Federal Reserve cited the relationship between these two metrics.

So what should we make of this? The challenge with this relationship right now goes back to the Magnificent Seven and that so much of the S&P 500’s valuation is driven by its most expensive stocks. Consider that the earnings yield of the equal-weighted S&P 500 right now is 6.3% – more than 1.5% higher than the yield on 10-year Treasuries. This is to say that the valuation of the stock market right now is significantly more appealing if we look past the largest and most expensive stocks. 

But here is where we will again make the argument that value stocks present a table-pounding long-term opportunity in investment markets. We explained the case in 2020 and the chart below presents just one visualization of the historical spread between value stocks and growth stocks. That said, we continue to maintain an increased allocation to value stocks in Golden Bell portfolios. This factor tilt provided great benefit to your portfolio in 2022 – a trend that has reversed in 2023 as the relative cheapness of value stocks has widened.

Closing Comments

We will reiterate what we have said before – the primary difference between investing success and failure is the time horizon employed. Unsuccessful investors tend to focus on the short-term whereas successful investors focus on the long-term. There is far too much noise-induced gyration in stocks and bonds to place short-term wagers when the ultimate goal is long-term success.

A big part of the role of high-quality financial advisors is to understand market, political, tax, and economic dynamics to help make wise investment and financial planning decisions. When we make investment decisions, they are always done with a long-term view. It is our hope and expectation that long-term portfolio tilts such as our elevated bias to value stocks will produce attractive benefit over the coming decade but how and when that benefit comes is unknowable.

A secondary role of high-quality advisors is to help explain and decipher market dynamics to clients so that they can better make sense of things. I hope that this letter has helped in that respect and welcome any questions you might have about investments, finances, or your retirement plan.

With Kind Regards,

Jason

It is completely reasonable to feel a sense of whiplash in the investment markets these days. One day, the stock market rallies a few percent on almost nothing relevant and the next day it gives back the gains for little reason. These daily gains and losses – as reflected below for the last 50 trading days – are not insignificant with roughly a quarter of the trading days experiencing a gain or loss of more than 2%.  

In many facets of life, it can be particularly valuable to step back and consider the big picture. This undoubtedly applies to investing where the noise of daily stock price movements or yesterday’s economic data creates distractions from what really matters.

Benjamin Graham, the father of value investing and perhaps the most influential investment mind of the 20^th century explains this in The Intelligent Investor (a book that Warren Buffet, Graham’s student at Columbia, describes as “the best book about investing ever written”):

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.

One would be hard pressed to find better investing advice than the four sentences above.

The ups of the market inherently come with downs. Frequently, these ups and downs in prices are driven not by fundamentals but purely by investor sentiment and emotion.

What then is the best way to reduce portfolio volatility? Look. Less. Often. While that may come off as cavalier or insensitive, it could not be more candid and truthful.

Imagine for a moment that your home had a market price that updated intraday just like the stock market. In this world, you would almost certainly experience several days each year where the market price of your home declined by more than 10-20%. Not over the course of a year. On a Wednesday in April or a Tuesday in August. Simply because there were no interested buyers that day or because yesterday’s potential buyers changed their minds and backed away.

The irony is that most Americans perceive single family homes as a good investment largely because there is no daily price (FWIW, single family homes have historically been a lousy investment if homeowners spent time running the actual math as detailed here, here, and here) . Aside from monthly Zillow estimates – which many people brush aside as misinformed – homeowners generally only see two market prices over the course of their investment – the day when they buy their home and the day when they sell their home. Generally, years or decades separate these two points.

Many homeowners would lose their proverbial minds if there was an intraday market for their home and they could see the value fluctuate in real time – if they regularly watched the market price of their residence plummet by more than $100,000 from the prior day. Which it would. The number of potential buyers for any home is a miniscule fraction of the number of potential buyers for a liquid exchange traded fund (ETF). The basic economics here implies that the daily volatility of a home – if there was a daily market price – would be far, far greater than the daily volatility of a liquid investment portfolio. But because we avoid daily updates on the value of our homes, we irrationally think of these as solid, stable investments.

There are important lessons here when we think about assets such as stocks and bonds with market prices that fluctuate daily:

Mental Sanity

Start with the mental health benefit of following investment markets less frequently. As Ben Graham implies above, investors who turned off their access to market quotes would be spared the repeated mental anguish of regularly seeing their investments lose value. Looking at a portfolio of stocks at the end of each day since 1950 would have meant experiencing defeat about half the time (46% of all days). Alternatively, looking at a portfolio of stocks only once every decade during that stretch drops the probability of experiencing defeat to 7%.

Looking often at your investments is going to cause anguish about half the time. Regularly absorbing the daily financial news is going to cause anguish most of the time because news media leverages something called “negativity bias” – the known tendency of humans to respond more to threats and turmoil. Warnings of danger or prognostications of doom get more attention, more clicks, and more revenues for media companies. So, what we tend to get is far more bad news than good. More anguish and mental stress and loss of sleep – none of which are healthy for the human body. One of my peers has a good rule of thumb for life that is relevant here: “Don’t do things that make you feel terrible unless you have a very good reason.”   

Investment Performance Benefits

Second, robust evidence demonstrates that the more frequently investors review their accounts, the worse they perform. Why? Because investors who view their accounts more frequently are more likely to act and action tends to be counterproductive to financial success. In a famous research paper, two professors from the University of California were given access to anonymous transaction data over a multi-year period from thousands of accounts at a discount brokerage firm. They found that the stocks that investors sold outperformed those they kept by 3.4% over the ensuing 12 months. 

Another study done by Fidelity Investments separated investors into deciles based on how frequently or infrequently they logged in to view their accounts. Who had the worst performing accounts? The decile of investors who logged in most often. And who had the best performing accounts? The two deciles of investors who never logged in to view their accounts. When the researchers called the owners of these best performing accounts to better understand their ability to maintain discipline, they found that the overwhelming majority had either forgotten they had an account at Fidelity or that the original owner was dead and the estate assets were yet to be recovered.   

Less Noise = More Time

Finally, the daily and weekly and monthly movements of the market, the related explanations for why the market went up or down, and the predictions of why the market is likely to fall or rise next quarter do not matter to your financial plan. Let’s call all of this exactly what it is: Noise. We will again experience wars, recessions, terrorist events, pandemics, geopolitical threats, corporate fraud, and other scary conditions just like we did over the past 90 years when the S&P 500 Index provided a cumulative return just shy of 1.2 million percent.

Your time would be far better spent by connecting with people in your life, by going for a walk, by listening to music, by exercising, or by reading a book than by paying attention to financial noise.

Rock-paper-scissors ranks somewhere near the top of a list of universally known childhood games.  The game separates itself from games of pure chance like coin flipping or the card game war in that participants can gain an advantage by recognizing non-random behavior patterns of an opponent. Successful participants recognize patterns to determine how the opponent is likely to follow a winning paper throw or a losing rock throw.

Such predictive forecasting, a trait which separates humans from other species, serves us well in life beyond a simple game of rock-paper-scissors.  The use of nitrogen to expand agricultural yields or antibiotics to cure illnesses initially resulted from the same kind of advanced pattern recognition.

As a species, we have a demonstrated behavioral aversion to ambiguity and need for control.  Resultantly, it is in our nature to look for patterns in rock-paper-scissors or other aspects of life.  We make predictions about the future based on pattern recognition, celebrating the successes as a result of skill while attributing mistakes to bad fortune.  A good investment is the result of intelligence and preparation whereas a bad investment is the fault of extraneous events.  Our ill-conceived perception of successful pattern recognition reinforces an already inherent overconfidence bias.

To demonstrate our bias to look for patterns, an interesting experiment was done during the 1970’s which pitted the predictive ability of Yale undergraduates against a rat.  The rat was placed in a T-shaped maze with food placed on either the left or right side for each trial.  The sequence, unbeknownst to the students or rat, was random but arranged so that the food would be on the left side 60% of the time and 40% of the time on the right side.

The rat eventually learned that the food was more often on the left side and nearly always chose that direction.  As a result, the rat was successfully rewarded with food 60% of the time.  The students were asked to predict the side in which the food would appear.  In keeping with a natural aversion to ambiguity, they looked for subtle patterns in the food placement and predicted the correct side just 52% of the time.  Insistence on finding a pattern such as an alternating two left – one right sequence meant that the students were far less successful at prediction than the rat.

If the idea of being worse at prediction than a rat is discouraging, then perhaps it may be uplifting to learn that even the highly educated “experts” on TV and radio who are paid for their perceived expertise are no better at predicting the future than you, me, or the rat in this experiment.

Renowned behavioral psychologist Phillip Tetlock spent nearly 20 years examining the forecasting ability of experts and wrote an excellent book titled “Expert Political Judgment” on the findings.  His study of 284 people who made a living “commenting or offering advice on political and economic trends” may be the most expansive study of expert predictions ever conducted.  These experts made predictions about the future on questions like would George Bush be re-elected, would the dot-com bubble burst, and whether GDP growth exceed a certain level.  By the end of the expansive study, Tetlock reviewed 82,361 forecasts.

The results demonstrate that we are better off relying on random guesses for forecasts of the future than on economic or political experts who write books, appear on TV and talk radio, and get paid to provide predictions.  Tetlock says, “Even the most astute observers will fail to outperform random prediction generators – the functional equivalent of dart-throwing chimps.”  Notably, Tetlock’s findings are no different than more than a hundred other studies that have compared expert predictions to simple statistical formulas.  Humans, expert or otherwise, are just bad at making predictions.

The Impact of Lousy Forecasting

Once we come to the admission that not just the local weatherman but all 7.1 billion of us are poor at prediction, what comes next?  There are two simple, powerful, and behaviorally difficult consequences for successful investing.

1) Ignore the “experts”

Tetlock scrubs the data in his 20 years of research to look for any useful indicator of expert predictive success.  He finds that education, expertise, nor even knowledge of confidential information are not useful determinants of forecasting success.  In fact, the more confident a forecaster is about the future, the greater depth of the expert’s knowledge, or the more famous the expert is, the less likely the predictions from such experts are accurate.

There are several explanations to help understand why forecasters are so poor at their job of forecasting and why the public continues to value their advice, despite the inaccuracy of forecasting.  First, we are all inherently biased to overweight the likelihood of low-probability events.  Robust behavioral research demonstrates that human brains have trouble comprehending probabilities and forecasters are no different.  Second, we are seduced by elaborate stories more than by simple probabilities so forecasters give us what we want.  Third, forecasters become successful not by hitting singles but by hitting home runs – making the prediction that no one else saw coming.

As a result, the most prominent forecasters are not successful because their predictions are accurate but because they create elaborate, well-reasoned, and unique predictions that differ from the mainstream.  Incumbents win over 85% of Congressional elections and the US stock market produces a positive return in 87% of all 5-year periods.  But forecasters do not make a name for themselves by simply predicting that such high-probability events are likely to persist, even though that extensional probabilistic reasoning is likely to be accurate.  They instead become famous by creating imaginable narratives to explain why incumbents are likely to be defeated or the stock market is likely to fall over the next five years.  Quite simply, they swing harder for forecasting home runs.

When occasionally correct, “forecasters are skilled at concocting elaborate stories about why fortune favored their point of view.”  When wrong, they succumb to the hindsight bias – systematic misremembering of past predictions and claiming they knew more about the course of history than they actually knew.

There is no shortage of free expert opinion on the direction of interest rates, oil prices, the dollar, or stock prices.  Yet most advice is free for a reason.  We would all be well served to rely on historic evidence and probability rather than a forecaster’s plausible story about why the dollar is likely to appreciate or interest rates to rise.

2) Ignore our instincts

It is easier to look at experts in any field and criticize their mistakes or poor success as forecasters than it is to look in the mirror and admit our own predictive failure.  The reality is that we’re all lousy at prediction, even if we have convinced ourselves otherwise.  Our inherent behavioral biases cause us to make bad decisions and to look for meaning when there is none.  According to Tetlock, “human performance suffers because we are, deep down, deterministic thinkers with an aversion to probabilistic strategies that accept the inevitability of error.  We insist on looking for order in random sequences.”  Furthermore, we hate to be wrong.

This inclination to refuse an explanation of chance and to seek patterns in random phenomena is expensive for investors.  Rather than admit the future is unknowable, we are inherently tempted to look for patterns.  Many investors continue to chase returns, jumping in and out of the stock and bond markets despite robust evidence to indicate the high cost of this futile exercise.

Saving Ourselves from Ourselves

Picking trendy investments and forecasting market swings is compelling to our behavioral biases.  As with a simple game of rock-paper-scissors, we believe that we can seek out patterns and use the patterns to predict the future.  It puts us in control and that is far more appealing than an admission of the alternative.

As we have noted before, we believe that there are three types of investors:

• those that know they don’t know the future direction of financial markets;
• those that don’t know that they don’t know; and
• those that know that they don’t know but get paid to pretend they do.

At Golden Bell Financial, we are admittedly in the first category of investors.  As a result, our investment discipline ignores market forecasts of our own or others.  We do not seek out the next great star fund manager.  We dispose of our pride and recognize that human tendency is to behave badly as investors.  We ignore our hunches, ignore the “experts”, and rely on long-term disciplined investing, adding incremental value through less glamorous value-added steps such as diversification, asset location, factor-tilting, and cost-managed rebalancing.

Fortunately for our clients, much of the investment advisory industry consists of the other two categories of investors.  This means that behavioral inefficiencies will continue to exist which we seek to exploit by favoring cheaper investments and profiting as wealth transfers from the impatient to the patient.

When trading closed last Friday (6/30/2022), the S&P 500 Index concluded its worst first half decline in 60 years. During the first six months of 2022, high inflation spurred the Federal Reserve to raise interest rates sharply which raised the risk of recession and dragged down the value of stocks.

This marks only the 6th time since the inception of the S&P 500 Index in 1926 that this benchmark for US stocks has declined by more than 15% in the first six months of a calendar year.

It is worth noting that in all of the five prior instances, stocks posted unusually robust gains in the 2nd half of the year.

The sample size is limited but it does support a useful reminder: risk and return are inextricably linked. When stocks go down, they get cheaper. When stocks get cheaper, their future expected return increases.

Investors all too often look at the stock market through the flawed lens of recency bias, expecting that the recent past offers a useful predictor of the immediate future. However, history provides evidence of just the opposite – that after stocks get pummeled, they generally bounce back. After stock valuations get cheap enough, long-term investors are often rewarded with outsized gains.

This is not to say that stocks provide bargain valuations or to make the case that the stock market is due for a 2nd half recovery. It is just a reminder that stock market losses often pave the way for stock market gains.

Individual investors tend to be terrible at investing. This is by design. Human brains evolved over millions of years to survive – not to be good at investing. For our ancestors, overweighting every little sign of danger was rational and waiting until things calmed down was necessary for survival. It helped them to avoid being crushed by wooly mammoths or mauled by saber-toothed tigers. The behavioral bias to wait for safety results from millions of years of adaptation.

Yet while this bias was useful for the survival of our ancestors, it turns out to be terribly counterproductive for modern day investing. Robust empirical evidence suggests that bad investor behavior – selling when the world feels ugly and buying when it feels good – may cost investors somewhere between 4% and 8% per year. Humans – in aggregate – collectively become most optimistic or most pessimistic at the least opportune times.

The good news is that we can use these consistently damaging tendencies to our advantage. Because humans inherently respond to fear and greed in the way they do and because these investing tendencies are generally counterproductive to economic success, investor sentiment is universally accepted by practitioners and academics as a contrarian indicator. Still, Wall Street has a vested interest in not promoting this tendency because retail investors imprudently trading on their fear and greed helps drive the profits of Wall Street brokerages.

The more bearish and fearful investors become, the more likely we can expect higher returns in the future. There are many ways to measure the mood of investors and we use a few of the more reliable measures to help gauge the attractiveness of stocks based on investor sentiment. Three of those measures are briefly explained below:

1. AAII Survey Data – The American Association of Individual Investors Sentiment Survey is a weekly survey that has been conducted since 1987. AAII members are asked to predict the direction of the stock market over the next six months as up (bullish), no change (neutral), or down (bearish). Investor sentiment is deemed pessimistic when bearish votes exceed bullish votes.
2. VIX – The CBOE Volatility Index (referred to as the VIX) uses option prices to objectively measure market-implied volatility over the next 30 days. A high level of implied volatility means that investors are fearful and that they perceive higher levels of risk in the future.
3. Put/Call Ratio – The equity put/call ratio is simply a measure of the number of traded equity put options divided by the number of call options. Because put options provide insurance for investors (limiting the downside), a higher level in this ratio reflects fear as it means that investors are buying more portfolio insurance.

Current Sentiment

As it stands right now (June 30, 2022), all three of these sentiment measures reflect abnormally high levels of investor pessimism. This is only the 4^th month-end point over the past two decades where all three of these measures are more than 1 standard deviation above average (to the pessimistic side) at the same time (October 2008, January 2009, February 2020 being the others).

The following chart provides some evidence of the utility of investor sentiment as a contrarian indicator. Following the three prior points when these measures unanimously reflected extreme investor pessimism, the S&P gained an average of 10.8% and 24.7% over the ensuing six and twelve months.

The bottom line is that it is generally unproductive to sell stocks at points like today when sentiment is extremely bearish – when things seem the scariest and the future feels most grim.

1) A 10-year bond purchased today should return about 2% more per year over the next decade than a bond purchased at the start of 2021

How do we know? Because the current yield on bonds is extremely efficient at foretelling the return on high grade bonds. The chart below tells this story. For every month dating back to 1976, we measure the current yield on the 10-year Treasury note at the start of the month and the return over the subsequent 10-years for the Bloomberg Aggregate Bond Index. The plots below represents those 437 monthly data points¹.

You can see the distinct and clear linear relationship from the data. The higher the starting yield, the higher the return over the next 10-years. Of course, we don’t know the path that bond returns will take over those 10-years. But, we can say with a high degree of confidence that bond returns over the next 10-years should be significantly higher than bonds purchased 18 months ago just for the fact that 10-year Treasury yields are roughly 2.2% higher than today than they were 18 months ago.

2) Recent changes in interest rates really do not offer any predictive utility about future changes in interest rates

The concept that interest rates will keep going up because they have been going up is based entirely on emotion or heresay rather than on empirical evidence or objective data. There is just no evidence that supports this theory. Consider the data below where we compare the change in 10-Year Treasury yields over the past 3 months (horizontal axis) to the change in 10-Year Treasury yields over the next year (vertical axis). Again, the plots represents each beginning-of-month data point since January 1976.

Try your best but you will not find any relationship between the two. The amount of variability in future interest rate changes over the next year predicted by changes over the past three months is a whopping 0.1% which is to say that there is no connection between recent changes in interest rates and future changes.

3) Federal Reserve rate hikes tend not to harm long-term bonds

The futures market suggests that the Fed is likely to increase the Federal Funds Rate by another 1.75% – 2.25% in 2022 beyond the 50 basis point hike last week. Many take this to mean that interest rates are headed higher. What is not well understood is that the Federal Reserve does not set or directly control intermediate and long-term interest rates that matter most to bond prices. The Fed uses open market operations to target a level for the rate that commercial banks charge between themselves on overnight loans. This extremely short-term rate has a strong impact on the yield of money markets, bank savings accounts, and floating rate loans but less an impact on longer-term rates which are a function of market expectations.

In all of the Fed rate hiking cycles this century, bond returns (Bloomberg Aggregate Bond Index) have been positive in the 1-year period following the onset of rate hikes. Going further back – to the start of 1976 – bond returns have been positive in 85% of one year periods when the Federal Reserve was hiking interest rates².

The chart below depicts this relationship with each plot representing the trailing 12-month change in the Fed Funds rate (horizontal axis) versus the 12-month return for the bond market over the same time period (vertical axis). Although there is a small relationship between the two, the more important takeaway should be that bond returns tend to be positive over most time periods, regardless of Fed policy.

Apple pie, baseball, and homeownership. We – Americans – extol homeownership as a pillar of the American dream and the right of passage that defines graduation to adulthood. Societal norms deem that owners are more financially successful than renters. Homeownership is such an integral part of the American dream that our government spends upwards of $100 billion each year to subsidize the institution via multiple tax breaks. Pervasive in American culture is the conventional wisdom that owning a home is better than renting one.

But is it? Are Americans really better off to own rather than rent? Are the economics of homeownership better than the economics of renting? Maybe. Maybe not. What can be said with some level of confidence is that most of the common justifications for homeownership are largely unfounded myths.

And to be clear up front, I do not come at this topic as a begrudging renter who abhors the societal pressures of homeownership. I am a long-time homeowner and do not regret the decision to purchase a home. Instead, I come at this from an economic perspective to dispel the unfounded myth that home ownership is fundamentally better than renting. It is not. In my experience, many consumers do themselves a terrible disservice by simply accepting the pervasive myths of home ownership. As a financial planner, what bothers is certainly not the institution of homeownership but rather the promotion and resulting acceptance of myths that lead consumers to make poor financial decisions.

Housing Myth #1: Renting is throwing money away.

In this sense, we throw money away when we eat a meal. When we drink a cup of coffee. When we shower or brush our teeth. All of these items have an associated cost just like renting a place to live. The idea that “renting is throwing money away” intrinsically implicates one of two things:

1) Anything that has a cost is wasteful including food, toothpaste, basic clothes, etc.; or

2) We do not need shelter – we could just live in the wild and so any expense associated with shelter is a waste.

Anyone who ever uses the “renting is throwing money away” argument inherently implies one of those two points. Pick number 1, number 2, or both because there are no other ways to support the “renting is throwing money away” argument.

We wisely choose to rent items because the economics of renting makes sense. For example, we rent a seat on a Delta 747 flight across the country rather than purchase a 747 for our personal use. We rent a car and a hotel room for a week’s vacation in a foreign city rather than purchase a car and small apartment for the week. No one ever suggests that renting a home for a weekend is throwing money away versus the alternative of purchasing a home to use for the weekend.

The economics of buying a home may work out to be better than renting – or vice versa. It depends on the circumstances. But the idea that renting is a waste of money is decidedly wrong and a misinformed narrative to justify buying over renting.

Housing Myth #2: If the monthly mortgage payment is less than the cost to rent a home, then buying is advantageous.

Decidedly wrong. This logic is founded on the idea that the mortgage payment is the only cost of owning a home. Not even close. Property taxes, home insurance, HOA fees, lawncare, pest control, flood insurance, and hurricane insurance are all costs associated with home ownership that result in an average annual expense of 2% – 4% of the home’s value (note that utilities are ignored here because these costs tend to be similarly incurred by renters and owners).

Beyond these regular and predictable costs are the erratic and unpredictable maintenance costs of owning a home. While maintenance expenses vary depending on the age of a home, upkeep costs average between 1% – 3% of the home’s value on an annual basis. Of course, homeowners do not need new carpeting, new roofing, fresh paint, mold remediation, tree removal, or new HVAC units each year but these expenses and other maintenance costs like them prove to be significant when aggregated over the course of a decade or two.

And yet there is still more. Many homeowners naively ignore one of the largest expenses of home ownership simply because it is intangible and easy to ignore – the opportunity cost of owning a home. And yet it proves to be a significant cost. The opportunity cost of any expense is the amount those dollars could have earned in an alternative investment. When someone purchases a home and writes a check for the downpayment amount, this value is not available for investment in other assets like a diversified stock portfolio that might yield a higher return. Homeowners would be wise not to dismiss this cost. A $250,000 downpayment – which otherwise would have earned a 5.5% real return annually over the next 10 years versus a 0.5% real estimated return for the property – has an opportunity cost of $177,224 over the course of a decade.¹

Lastly, any reasonable evaluation of renting vs. buying should include the costs incurred in buying and selling a home which tend to be massive. Real estate brokerage fees, appraisal expenses, attorney fees, loan origination costs, title insurance, underwriting fees, transfer taxes, and other closing costs tend to comprise 3% – 7% of the home’s value – on both the purchase and sale.

One of the most robust academic studies on the cost of homeownership evaluated housing costs of single-family homes in 46 metropolitan areas over a 25 year period and concluded that the annual cost of homeownership in the United States – on average, across geographies – was 5.0%. Economists refer to this cost as the imputed rent – the concept that you pay rent whether you own a home or not. The costs are transparent and easily calculable if you rent a home whereas the costs tend to be covert and/or volatile when you own a home.

Housing Myth #3: Rental costs go up every year whereas a fixed mortgage is stable.

A fixed mortgage is stable. But the other costs associated with owning a home tend to increase each year at an inflation rate that is similar to that of rental price inflation. Insurance costs, real estate taxes, lawncare, maintenance costs, and all the other aforementioned costs associated with home ownership also tend to go up each year – just like rents. Buyers should not trick themselves into believing that the costs of homeownership are magically fixed.

Housing Myth #4: Buying a house rather than renting allows an owner to take advantage of home price appreciation.

Perhaps, but several glaring mistakes are made in this logic.

First – and this will come as a surprise to many – a house is a depreciating asset over any meaningful time period. The day after a house is built and completed, it is at its peak value. Wear and tear and usage then begin to reduce the value of a house. The value of a home only retains value because homeowners invest money in the home to repair the roof, fix rotting wood, repaint walls, replace carpets, and make other necessary repairs. Without such maintenance expenses – the value of a house would eventually go below zero (where there is a demolition cost to get full value for the land). The reasons that home values appear to appreciate over time is that the land value appreciates and the money we sink into homes for maintenance is naively perceived as appreciation.   

Second, the idea that homes are a good long-term investment is a counterfactual myth successfully marketed by the real estate brokerage industry. Consider that since 1890 – a period of 131 years – housing prices in the United States have a real annual return of 0.59%². Keep in mind that this modest increase in value is largely manufactured by the maintenance costs described above which we inaccurately perceive as appreciation. Data in Europe goes back a few centuries and the results are similar. The average house value in London, for example, increased by 1.1% per year in nominal terms between 1290 and 2016.³ This roughly equals the inflation rate over that 700+ year time period meaning that home values kept pace with inflation but did not produce a positive real return.

We tend to exaggerate historic home price appreciation because our brains are inherently prisoners of the moment, assigning far greater importance to the recent past than to the more extended history. The chart below demonstrates that over the past five years, US housing prices have increased by nearly 6% per year – among the best five year periods ever. This recent history – where many markets have experienced after-inflation returns in excess of 6% per year – clouds our perception of the past in a potentially dangerous way.

As a result of this recency bias, we tend to rely on continued home price appreciation as a justification for home ownership when the multi-century history of home prices suggests that we might be foolish to rely on any appreciation as a case for buying versus renting.

Housing Myth #5: At least when I own a home, I’m and getting the tax breaks of deductible property taxes and mortgage interest.

This one used to be a legitimate claim but stopped being broadly true with the 2017 Tax Cuts and Jobs Act (TCJA). Prior to the tax law change in 2018, 31% of taxpayers itemized and there was no limit on the amount of real estate taxes that could be deducted. Subsequent to TCJA enactment, less than 10% of taxpayers now itemize and most of those who itemize get zero tax benefit from their property tax payments and only a limited benefit from their mortgage interest payments. That is – the TCJA dramatically reduced the benefits of homeownership and moved in the direction of leveling the playing field between renting and owning. The reality is that the overwhelming majority of homeowners – especially married filing jointly taxpayers – get no tax benefits or minimal benefits from either mortgage interest payments or property taxes, despite their perceptions to the contrary.

Housing Myth #6: Homeowners are happier than renters.

There is robust international research on this topic and no compelling evidence that homeowners experience greater happiness than renters. If there is evidence in one direction, it is for a negative relationship between homeownership and happiness. A robust 2011 paper by Wharton professors, The American Dream or The American Delusion, examines a large data set of women in single family homes to control for any gender bias. After further controlling for health, income, and housing quality, the authors find that the “average female homeowner consistently derives more pain, and no more joy, from their house and home” relative to renters. The added pain and displeasure for home owners is found to be significant. Furthermore, the authors find that female homeowners tend to spend less time on active leisure or with friends, experience more negative affect during time spent with friends, and find less satisfaction with their health than renters. In fact, the research shows that homeowners weigh 12 pounds more than those who rent, when controlling for other factors.

Additional literature studying Swiss homeowners and German homeowners presents no clear positive relationship between homeownership and happiness. Depending on how happiness is measured, the data often points to a negative relationship between ownership and happiness.

Presumably, more time spent on home tasks, repairs, lawncare, and maintenance by homeowners takes away from leisure or fitness activities. Coupled with this is that the added debt homeowners assume to purchase a home has a negative relationship with happiness. Evidence finds that households with more debt are less happy and have greater marital conflict.

Additional research shows that because homeowners often stretch their finances to afford a home and then put money back into their home for improvements, maintenance, and furnishings, that they have less to spend on vacations, eating out, and other experiences. Robust evidence over the past two decades finds that life experiences yield far more happiness than material goods and yet homeowners tend to do just the opposite of what actually generates happiness by sacrificing experiences in favor of material items.

Lastly, owning a home undeniably limits freedom and reduces flexibility. Homeowners are more anchored to their job, their lifestyle, their neighbors, their social network, their commute. Obviously, a homeowner can still change jobs or buy a new home closer to friends and family but the flexibility and ease for a renter to make these changes is far greater. Research and evidence overwhelmingly supports this case.

This is not to say there are no emotional or psychological benefits to homeownership. There clearly are. All else equal, research finds that people are happier when they have control over their own property. Owners can make improvements to a home for their specific desires – such as adding a deck or renovating a bathroom – something that renters cannot necessarily do. But the key takeaway from digging into the empirical research is that homeowners tend not to be happier than renters. Homeowners expect they will be happier and seek to justify a purchase by picturing greater happiness. The data, however, indicates that if there is any greater happiness, it is afforded to renters – not owners.

Housing Myth #7: When mortgage rates are historically low, I would be well served to purchase and lock in a low rate mortgage.

Low mortgage rates do not exist in a vacuum. All else equal, lower monthly interest costs increase affordability and attract more buyers (higher demand), which causes home prices to rise. Conversely, when mortgage rates rise, higher interest costs reduce affordability (lowers demand) and home prices tend to decline.

Buying a home when mortgage rates are low is not – in itself – a flawed approach. But buyers should be aware this is not a free lunch and that higher mortgage rates in the future may be accompanied by declining home values.

Housing Myth #8: Owning a home by the time I retire will help reduce my retirement expenses and likely give me a better financial outcome.

Only by way of sneaky mental accounting and not by objective economics. The problem with this myth is that buying a home requires an upfront investment and monthly mortgage payments. If we consider the purchase of a $500,000 home with 20% down, this purchase requires a $100,000 upfront investment and principal payments each month starting at around $630 and increasing over time (as the interest component of the mortgage amortization declines). Those amounts – the $100,000 initial payment and the monthly principal payments reduce the value that can be invested for retirement. As a result, they reduce the nest egg that someone has to draw off of in retirement.

It is true that once the home is paid off, the monthly cash flow burden is less than it would be for a renter. But, this ignores half of the equation. If all we know is that someone spends $8,000 per month in retirement, there is no way to assess whether this is good or bad – whether it is viable in the long-run or not. The useful way to evaluate retirement spending is the monthly cash flow burden divided by the amount of financial assets – what is referred to as the “retirement distribution rate”.

If a renter keeps the upfront payment of $100,000 invested that the buyer used as a downpayment and she wisely invests the excess savings each month not going toward mortgage principal payments, then she ends up with significantly more financial assets to support retirement spending. So while her cash outlays may be higher each month, the distribution rate – which will ultimately be the judge of her financial success in retirement – could be lower or higher than the owner – depending on the underlying economics.

Concluding Comments

None of this is intended to discredit homeownership or encourage renting. The purpose is simply to dispel some of the flawed arguments supporting home ownership. There are a lot of narratives to support the American dream of home ownership but many of them – especially the “renting is throwing money away” narrative or the concept that home prices appreciate at an attractive rate over time – rely on misinformed facts or faulty logic.

We often use a robust spreadsheet with numerous inputs to evaluate the estimated breakeven period – the length of time required for the economics of home ownership to surpass that of renting given variables specific to the location.⁴ It is generally true that the holding period in a specific geography needs to exceed seven to ten years and sometimes longer before the economics favor buying a home versus renting. This is just the quantitative side of the equation and does not consider the flexibility or added leisure time afforded to renters.

The underlying takeaway is that consumers would be wise not to dismiss the economics of renting based on misguided narratives, societal pressures, and false logic.

For over a decade following the financial crisis, economic and market pundits talked regularly about the risks of deflation. What is the Fed going to do to combat the threat of deflation? Are they doing enough? Is the European Central Bank doing enough? What if we get stuck in a deflationary spiral? 

The Fed pushed on a string for 13 years following the financial crisis to get to their targeted 2% inflation level. Zero interest rate policy (ZIRP) and multiple rounds of quantitative easing had limited success in stimulating inflation. Until 2021 – when it was not so much the result of Fed activity but rather a global pandemic that triggered significant supply chain disruptions and labor shortages.

And then the conversation took a 180-degree turn. When is inflation going to subside? Is the Fed going to do anything to curtail this wild inflation? Are we headed toward hyperinflation? How should we prepare for hyperinflation?

And so it goes. Let’s pause and consider a few empirical facts:

• Humans will invariably overweight events of the recent past. This recency bias is a trick that our brains play on us – a useful bias for survival but one which imposes a high cost for investing.

• Human brains are seduced by and drawn to the most extreme predictions – not the most well-reasoned and probable predictions. As a result, airtime and web traffic goes to the forecasters promoting the most extreme views and outcomes.    

• Forecasters do not become famous (and wealthy) by making mainstream predictions. They do so by creating imaginable narratives of extreme outcomes.

• Bad predictions are rarely – if ever – punished. Economic and investment predictions tend to come without a finite time horizon or a long-enough horizon that has them forgotten by the time they could be disproved. Moreover, it is neither in the forecasters’ nor media’s best interest to highlight the overwhelming futility of past predictions. There is – as a result – limited accountability and reputational risk for making extreme (and wrong) predictions.

The net result is that we get overwhelmed with extreme predictions about the future that a) have a compelling narrative attached to them; b) generally overweight the recent past; c) will be difficult to disprove over a reasonable time period; d) will likely be forgotten if wrong; e) will be promoted in the rare case they are right; and f) are generally free to consume but costly to heed.

We are somewhere in the early innings of this unhealthy narrative on the inflation topic. Recent inflation expands. Maybe it becomes hyperinflation. Bonds fall precipitously. The stock market plummets.

It may be helpful to stop here and appreciate the likely triggers of recent inflation, consider the investment implications, and then relax.

The Great Resignation

Since the start of the pandemic, you have undoubtedly been impacted by the unprecedented labor shortage on a regular basis. Industries from restaurants, retail, and schools to airlines, manufacturing, and healthcare have all been hindered by significant labor shortages. With a historic number of job openings (10.6 million as of January 4^th report), hiring remains the biggest challenge for businesses of all sizes.

The labor shortage is far from abating. Nearly 5 million Americans have left the labor force since the start of the pandemic. Some have retired early, some quit to start their own jobs, and some have just exited the labor force because – according to a Joblist poll – their jobs did not provide work-life balance. Whatever the cause, the contracted labor pool comes at a time when surging consumer spending necessitates more workers – not less.

The result has been wage hikes as employers seek to retain and compete for a limited base of workers. New York City subway drivers have been lured out of retirement for temporary 3-month jobs paying $35,000. Desperate restaurant owners in parts of the country have been forced to double their hourly wage ($7.50 to $15.00) to attract and retain employees. These higher labor costs – 4.7% higher than a year ago – have fed into higher consumer prices and added to inflation pressures. Consumer goods and services are 7.0% more expensive than a year ago – the largest rate of increase since the early 1980’s.

As a result of labor shortages, extreme weather, geopolitics, and unusually high demand, inventory backlogs exist in nearly every industry. Global supply chains continue to be constrained as evidenced by unprecedented supplier delivery times, port backlogs on both coasts, and historic shipping costs. The Freightos Baltic Index – which measures global container shipping prices – stands at $9,167 to ship a 40-foot container – roughly 3x the cost at the start of 2021.

How Will Elevated Inflation Be Resolved?

1) Expanded labor force

The reduction of federal unemployment benefits and the child tax credit should aid in expanding the labor force by bringing more persons back to work. The same can be said of a subsiding pandemic which – coupled with higher wages- should bring Americans who exited the workforce at the onset of the pandemic, back to work. That said, the surging Omicron variant has delayed this trend – keeping would-be workers at home to care for sick family members, to satisfy quarantine or isolation requirements, and to take care of school-aged children as schools temporarily revert back to remote learning.

While getting domestic persons back into the labor force is a step in the right direction, another part of the solution to the significant domestic labor shortage will likely come via legalized immigration. Immigration reform within the Build Back Better Act is stalled in the Senate and may not be revived but political pundits believe we may get piecemeal reform in 2022 to help expedite the enormous green card backlog (9 million applications in backlog) and to improve the H-1B visa program.

2) Tighter monetary and fiscal policy.

Fiscal stimulus in the form of expanded tax credits, stimulus checks, and social spending is scheduled to abate in 2022 from 2020 and 2021 levels. Furthermore, the Federal Reserve has already tapered its bond purchases and hinted at three rate hikes in 2022 – starting as soon as March. All else equal, the tighter fiscal and monetary policy should result in curbed consumer demand and reduce price pressure on goods and services.

3) Stabilized Energy prices.

An overlooked but important source of inflation in 2021 was the dramatic rise in energy prices (oil prices rose by 58%) which fed into every other industry. Nearly the entire increase in most food prices in 2021 from fruits to meats to coffee can be tied to the significantly higher cost of transportation. Higher oil prices also contributed to higher input costs for plastics, cosmetics, and textiles.

The OPEC production cuts and extreme weather conditions in energy-producing regions that triggered higher energy prices in 2021 are unpredictable in 2022 but more stable demand should result in more stable energy prices this year.

4) Higher mortgage rates.

While home prices are not directly part of the consumer price index (CPI) measurement, they take on an indirect role by way of the owners’ equivalent rent (OER) measure. OER is easily the biggest component of the inflation measure each month – representing a larger share than food and energy, combined. The hot housing market – which impacted rents and home prices – clearly had a meaningful impact on inflation in 2021.

The housing inventory shortage of roughly five million homes is obviously not something that gets resolved overnight. But the demand side of the equation is likely to be tempered by higher mortgage rates. The average 30-year mortgage rate is now above 3.2% from a 2021 nadir of 2.65%. Homeowners who refinanced to sub 3% rates in 2020 and 2021 will be less inclined to move and reset to a mortgage rate which is significantly higher than what they have now. This does not solve the inventory shortage but it likely reduces the number of potential buyers which should cause home price inflation to subside.

Investment Implications

It is worth reiterating the following points about inflation and the investment ramifications.

1. Price inflation is always a concern we seek to protect for in our portfolio construction process – especially for retirees who do not have the offsetting benefit of wage inflation. It is not and never will be a temporal concern.
   
   
2. The market prices in an expectation for future inflation. The current estimate of inflation over the next 10 years is 1.75% per year (using Treasury yields, inflation swaps, and survey-based measures of inflation expectations).
   
   
3. There is a troubling perception that bonds should be avoided if inflation is imminent. As a reminder, current inflation expectations are reflected in current bond prices so avoiding bonds when inflation expectations are already high is akin to buying home insurance after a fire.
   
   
4. Individual investors who seek to bet on inflation often fail to understand several things but namely that they are not betting on inflation – they are betting on inflation being higher than what the market already anticipates. To be clear – the market already digests that annual inflation over the past year is 7%. This is not a little-known secret.
   
   
5. Inflation is currency specific. That is, asset prices may rise in US dollar terms but not necessarily in Japanese yen terms. As a result, healthy global diversification tends to provide a hedge against domestic inflation.
   
   
6. A diversified portfolio that includes stocks is arguably the best hedge against elevated inflation. Stocks represent businesses and those businesses tend to pass higher producer prices onto consumers in the form of higher consumer prices. Historically, stocks have performed well during periods of higher-than-average inflation.
   
   
7. The Fed is expected to slowly begin raising interest rates in March by one quarter of a percent in response to inflation pressures. The Fed Funds rate is expected to remain below 2.0% through 2026. Although less accommodative than today, Fed policy over the coming years is still anticipated to be very market-friendly.
   
   
8. When the Fed “raises interest rates”, it uses open market operations to target a level for the rate that commercial banks charge themselves on overnight loans – a rate referred to as the federal funds rate.  This extremely short-term rate has a strong impact on the yield of money markets and bank savings accounts but less an impact on longer-term rates. The Fed raising interest rates does not have a direct negative impact on bonds or stocks. Subsequent to the start of the last two Fed rate hike cycles (June 2004 and December 2015), bonds and stocks both experienced healthy gains over the following year.
   
   
9. Value stocks tend to provide an excellent hedge to inflation because of their cash flows and the way that stocks are valued. We overweight value stocks in Golden Bell portfolios not for this reason but it can provide a valuable biproduct if interest rates rise.

Closing Comments

Today’s headlines publicize inflation hitting an annualized rate of 7.0% – its highest level since 1982. Investment pundits will use this as an opportunity to covertly or overtly sell inflation protection. Investment product providers will tout their funds that fight inflation (which may or may not be accurate). Financial news media outlets will use the opportunity to publish scary headlines. Talk show hosts will cite alarming government debt figures and inflation as a reason to buy gold (which – by the way – lost value in 2021 during a period of the highest inflation in 40 years because it is a poor hedge against short-term inflation).

It is worth repeating that the Fed and other global central banks have spent the past 13 years throwing the kitchen sink of monetary stimulus at the economy to get some inflation. Now, we finally have some inflation and conversation has flipped to the other extremes.

We cannot be certain of anything in the future but signs point to the rate of inflation subsiding in 2022 for reasons mentioned above. That said, our investment approach is NOT one of taking a binary view of what will happen in the future and then betting portfolios on that scenario happening. Instead, our approach is to consider all the things that can happen in the market and in the economy and in your life and to diversify assets such that whatever scenario plays out, you will be OK. Even if inflation stays elevated for the next year, it is hard to be better situated than by owning a globally diversified portfolio of stocks and bonds.

The big question on Wall Street in 2021 has been: ‘What happens with interest rates and inflation?” There are two competing views as we explained back in July – one that the recent uptick in inflation is transitory with temporary supply-chain disruptions and the competing view that inflation pressures are here to stay with long-term labor shortages, government budget deficits, and a stockpile of household savings.

There is no shortage of forecasts or predictions on this topic but the historic truth is that no one forecasts inflation well. The economy is incredibly complex and, as a result, both economic activity and inflation are highly unpredictable. The consensus market forecast for inflation is baked into stock prices and interest rates and that is probably the best predictor of the future. Taking a different view than the market consensus is simply a speculative gamble.

Our investment approach is NOT one of taking a binary view of what will happen in the future and then betting portfolios on that scenario happening. Instead, our approach is to consider all the things that can happen in the market and in the economy and in your life and to diversify assets such that whatever scenario plays out, you will be OK. That said, one of the long-term investment tilts we employ in Golden Bell Financial portfolios is one toward value stocks. Many of the underlying equity funds we employ have a strong value bias meaning that the funds are allocated more towards cheap, out-of-favor stocks and less towards expensive, sexy stocks. Historically, there has been a persistent, robust, and economically intuitive advantage to value investing across time periods, geographies, and markets. That is the advantage we seek to capture over the long term.

One interesting biproduct of this value bias is that it may provide a hedge against inflation and rising interest rates. While that is not the reason we employ this bias, it could provide useful insurance in the event that higher inflation is more than transitory.

First, it is important to understand that higher inflation expectations results in higher interest rates, all else equal. If an investor perceives that $100 is going to be eroded by higher inflation over the next 5-10 years, she will require a higher rate of return to compensate for this inflation erosion. It is a simple supply/demand equation. If investors expect 10-year inflation to run at 3%, then there will be less demand for a 10-year bond yielding 1.5%. The bond price will decline resulting in a higher yield (higher interest rate) until supply and demand are back in equilibrium.

But what does this have to do with value stocks and growth stocks? Generally, growth stocks are exciting companies with lofty future expectations. Unprofitable growth companies like Snapchat or Uber are not expensive because of current profits (they don’t have any). They are expensive because of an expectation that they will eventually post large profits in future years. And the fundamental way that stocks are valued is based on something called a discounted cash flow model where future profits are estimated and then a discount rate is applied to these future profits to assess the present value. The lower the interest rate, the more valuable these future profits.

If Snapchat is expected to finally earn a profit in 2025, the profit is going to be less valuable to shareholders if interest rates today are 5% rather than 1%. This is how discounting works. When interest rates are effectively zero, there is little opportunity cost to waiting for future profits. But when interest rates are higher, those future profits are less valuable because the alternative of getting 5% per year for the next five years in a low-risk bond presents a more attractive alternative.

Value stocks, alternatively, tend to be less dependent on future profits because they have current profits and current cash flows. Stocks like Procter & Gamble, Walmart, or ExxonMobil are not relying exclusively on future profits – they have profits today. As a result, investors do not have to depend on cash flows in the future and the price of these stocks is less dependent on discount rates (interest rates).

The net result is that growth stocks, in aggregate, tend to be more tied to interest rates than value stocks. When interest rates decline, it tends to be favorable for growth stocks relative to value stocks. When interest rates increase, the opposite is true – value stocks tend to outperform growth stocks.

The two charts below demonstrate this phenomenon. The first chart reflects the days in 2021 with the largest increase in 10-year Treasury yields and the resulting performance spread between the Russell 1000 Value Index less the Russell 1000 Growth Index. On February 25th, for example, the 10-year Treasury yield increased from 1.38% to 1.54% (a change of 0.16%) and value stocks outperformed growth stocks by 1.1%. On every one of these days, value stocks experienced a sharp return advantage over growth stocks.

Alternatively, we see the reverse when interest rates experience a sharp decline: value stocks underperform growth stocks.

The objective here is not to encourage a value bias because interest rates might rise. That said, there may be an advantage to value stocks within a portfolio context if inflation is persistent and interest rates resultantly rise. Although this interest rate hedge of value stocks is by no means guaranteed, it can be a valuable biproduct. We definitely do not own value stocks for this reason but this interest rate relationship is something we consider when thinking about the interest rate sensitivity within a portfolio framework.