Mike: Hello everybody and welcome. Thank you so much for joining us today. I'm Mike Hengehold and with me today is Doug Johnson. Doug of course chairs our investment committee here at HCM. Before we get started, I have just a few administrative items I need to take care of, and then we'll get on with it.
First, if during the presentation, you have any questions that you'd like to pass along. Feel free to do that with the Q&A button at the bottom of the screen. If you look and it's not there, if you go hover at the bottom of the screen, it should magically appear. If you would like copies of the slides after the presentation, let us know, and we will get those out to you.
However, we will have a replay of the presentation available on our website beginning probably no later than Friday at noon, something along those lines. Also, we are putting the finishing touches on a planning letter, something that summarizes a lot of the points that we've talked about in these calls over the last several months, and a lot of the things that our advisors are working with clients who have called to schedule year end planning meetings. So, we want to just to get all those ideas out to everybody for one last review.
Don't forget that the clock is ticking. Some of the ideas in the letter have an implementation window that we'll start to close here in the next few weeks, a couple of weeks before year end. So, by all means if you want to take some action, give us a buzz. And again, we'll be emailing that letter out to you in the next few days.
Finally, the festival of lights, this has been a very different kind of a year, but festival of lights is going on. If you want to go, don't forget that you need to make a reservation. And I think because of it being sort of a squirrely year, they're extending the period for a couple of weeks into January, at least a couple of weekends I believe. Laura will be sending out a reminder note next week. But if you're interested, of course we love sponsoring this event, this is the neatest thing we do for our clients and their families. So, if you'd like to participate just let us know. Respond to Laura’s note next week, or you can just pick up the phone and give us a call or shoot us an email and we'll be able to take it from there.
And I think that does it for the administrative notes. Since our last call, which was immediately after the election, at that time there were some questions about who was going to be president and so forth. Those questions have pretty much all been answered now and the only sort of election item that's still outstanding is who's going to control the Senate after that runoff election in Georgia. Obviously right now, the odds suggest that the Democrats will likely not win both seats in Georgia. And if they don't, then the Republicans will have a very slight control of the Senate, but enough to block some of those big actions that would probably have gone right down party lines. But while the odds favor the Republicans keeping control of the Senate, it's going to be by a razor thin margin. And even then, the odds of the Democrats not gaining control are low, but those odds are not zero.
And so, it makes sense to consider that possibility as you button up your year-end planning, both your tax planning and your family transfer planning, and sort of use that risk as a tiebreaker as you make certain decisions. And again, as always, we'll be happy to jump in and help sort those things out if you would like us to.
And so, with the election pretty much out of the way, today what we want to do is discuss some other issues that have our attention. The first in everything this year revolves around COVID one way or another. And so, the first thing we want to talk about is sort of the current state of affairs and recognizing the fact that the virus obviously does continue to rage. We see that in all the numbers that we see in the news every day. However, the market is a forward-looking animal, and the balance between the virus flaring now and potentially through winter until the vaccines get out and begin to have an effect, versus the market's ability to look through to normal times, is an interesting tug of war, so we want to talk about that. As we do return to normal, some things we've been talking about in the last couple of calls, there's an expectation that we would begin to see a rotation of certain types of investment classes. And we want to sort of give you a catch-up on that and see where that stands, and if that is in fact beginning to happen.
Finally, a practical concern for everybody who's either retired or thinking about retirement, are these super low interest rates. So, everybody realizes that the government has pulled interest rates down on the short end of the curve pretty radically to essentially near zero. That along with the slowing economy has brought interest rates to their knees pretty much across the board. And so, one of the challenges that we're focused on now is how do we deal with these low interest rates for retirement-oriented portfolios who rely on that cash flow to make everything work.
So, with that as sort of a foundation, Doug do you want to get started and talk a little bit about some of the COVID numbers.
Doug: Yeah, let's dive right into everybody's least favorite topic right now, which is COVID. I think everybody's kind of got COVID fatigue more or less. But here you get a good breakdown from the very beginning of this, a measure of tests, cases, hospitalizations, and new deaths (slide 2). And I think when we start with new cases, we've seen a very aggressive move up since right around the beginning of September. But what you've also seen is that it's been accompanied by a massive increase in new tests. So, something that's not on this page, but it's a figure that you've seen talked about a lot is a positivity rate.
We have all of these new cases, but the positivity rates are still fairly low. And when I say low, below 10%. So, the testing capability is certainly expanded, and I think that's captured a lot of the new cases. But the thing that the market I think pays attention to the most is going to be the columns on the right, both hospitalizations, and then, deaths (slide 2).
And obviously Mike, you've talked about this before, that the death is the unfortunate aspect of this, and we don't want to see that. It's the hospitalization number that's really going to be the biggest issue. Mainly because as hospitals become overrun, that's when you really bring in the idea of further lockdowns. And further lockdowns, I think, is what scares everybody, because that is going to be something that would stress an economy that is still trying to recover. But if we go and implement these again, I know some people have said that some politicians have said not on the table at all. But we've started to see in certain parts of the country already, specifically California, a readvancement, so to speak, of some of these very restrictive policies.
So, as those hospitalization numbers go up, the idea that we could run into new lockdowns again, I think is the most concerning part. But Mike, if you want to speak a little bit to the vaccine information, I think that's kind of the bright spot of all this.
Mike: It is, just to rewind just for a moment, one of the things we've seen in other countries over the last month or so is them sort of getting painted into a corner and being forced to do modified shutdown versions. And of course, we see that even here with sort of different governors, implementing different types of rules, whether it has to do with restaurants, or public dining, or when restaurants have to shut down. Then again, they're using the tools and the levers at their disposal to try and keep us from getting to that point where more draconian measures would have to take place. Because obviously the broader shutdown, what we experienced in the late winter and spring, is something nobody wants to go back to.
In terms of the vaccines, obviously, all over the news, this is fabulous if we can pull this off. It seems as though the operation warp speed, Star Trekkies would know. The ability to get this out is getting the full force of the government. Great Britain has already accepted these, so they're going to be a little bit ahead of us. And of course the health objective is to get us as close to herd immunity as we can, as soon as possible. From a financial perspective and a market perspective, it's to sort of balance the yin and the yang of the near term financial consequences of the rising count of cases, and the potential stress on the hospital system to the market looking a little bit further out towards a return to normalization.
And certainly, the vaccines are the tool that are going to give us that. As well as, we have much better methods now for treating people who do get sick. So that the outcomes for those that are affected are much better.
Doug: Yeah, and I think that at the beginning of the month we saw the first real announcement of a vaccine that was going to be not only available that also supposedly works very well. The Pfizer vaccine was the first one, right after the election was announced 95% efficacy. And then the Moderna product after that.
So, as we saw that, we started to finally see kind of a bifurcation in the market, performance wise, that we haven't seen in a really long time. One that we've talked about, hopefully not acknowledge them, but one that we believe is worth paying attention to. And it's this idea of a rotation from the sectors that have kind of led the rally from the bottom, to the ones that we believe are going to lead the rally going forward.
So, this is a trailing three month chart, it's got a few lines in it (slide 3). And what you see is the performance differential between these four assets. Going back from September to really the beginning of November, there's not a whole lot of dispersion. But once November hits, you start to see things spread out a little bit, and that orange line at the top represents the I shares US value factor ETF. So, an ETF that screens specifically for things that are related to the value factor.
And when we've talked about the idea of this growth to value rotation. You can start to see now that over the past few months, as that vaccine information has come out and people have started to discount the idea that the economy can really truly open itself back up going forward. You're starting to see those asset classes and the parts of the market that have been unloved for a long time really start to perform well.
So just below that, you've got the blue line there, which represents a broad base of international assets. Which we do own in our portfolios. And then the purple line, which is the S and P 500, just the market. And then at the bottom, you have the green line there, which is the NASDAQ 100 or the QQQ, which has been really the elephant in the room, so to speak, in terms of returns this year. But the question now becomes going forward, will those trends reverse and will value start to kind of take a lead against growth?
Mike: So, from my perspective, I think that if this chart that Doug just brought up (slide 3). So if we go to the left, we get the mirror image of what we're seeing here. So, when we talk about a rotation, what we're saying is that the leaders from the first part of the year are likely to be the laggards going forward. And the laggards from the first part of the year are likely to be the leaders as the market shifts from looking at an economy that was very bleak, to one that now has a lot of prospects to get back in gear again. So, this is sort of the after the turn and then Doug, if you want to go ahead.
Doug: And we've talked a little bit about valuations and specifically what parts of the market may be overvalued and what parts of the market might be undervalued. What this chart shows is, this goes back to 1975, and it shows the relative return performance between the growth sectors and the value sectors (slide 4). And what you'll see there is that little yellow circle up in the top represents kind of where we are right now. And that top dotted line represents three standard deviations away from the mean, now this is just a statistical term that we don't need to get into a ton of detail about. But when you get three standard deviations away from the mean, it basically means that the trajectory of the level that the measurement is at is very unsustainable.
So even though we've seen one month of significant rotation, there's still a long long way to go in this. Where we think that there's a lot of runway here for value to begin to outperform growth, if we can maintain this trajectory. And it's not that it's going to happen in one week's time, but I think it could happen quicker than people expect. So, I think you need to be kind of positioned ahead of time.
And I would say for the most part of all the themes that we've kind of harped on and we've tried to adjust portfolios, and this is probably the one theme that I think that we have the highest conviction in right now.
Mike: The highest conviction, and it also sort of leans to the way we see the world. Pretty much all historical research suggests that over longer periods of time value does outperform, but you get these pockets, obviously, where other asset classes do better. Our dividend growth portfolio is a classic example of a portfolio that is value oriented and of course is built to provide growing income. But we're definitely leaning into this one.
And beyond value, there are other asset classes Doug's already mentioned, international stocks, and small cap stocks, as well, are likely to enjoy a tailwind as we get clearer vision of a better economy going forward.
Doug: So, one of the other hot topics has been the leadership at the top of the S and P 500 represented by an acronym that seems to change a lot but in this instance, it's FANMAG. Which basically stands for Facebook, Apple, Netflix, Microsoft, Amazon, and Google. And what this chart shows, specifically the bottom panel, again, we go back to that mean and the standard deviation number. This just shows basically a trailing one-year performance differential between those six stocks and then the other 495, in the S and P 500, and it's been pretty massive (slide 5). At its peak there we're looking at close to 80% and almost four standard deviations away from the mean. Now, again, when you're getting three, four, five, six standard deviations away from a mean, those trends are just simply unsustainable, they cannot continue. And we've seen a little bit of a peak there, up to 80, and we've almost worked half of that down.
So, I know we've gotten a lot of questions about these specific stocks and should we be adding them? Should we be owning them? The answer is that you probably already own them a little bit just because you own an index, but the promise of out-performance going forward probably lies in the other parts of the S and P 500, as opposed to what is really run significantly. This year especially based on the dispersion, between those six names and the rest of the market, so to speak.
One idea that that touches on is this idea of breadth. So, breadth is described in this chart as the percentage of stocks above their 200-day moving average, it's more of a technical term (slide 6). But what it can tell us is, are we just getting participation from a very narrow part of the market? Or are we getting participation from a broad range of companies? And it's pretty easy to tell when you get narrow participation, it's not necessarily a healthy route. Yes, it can sustain itself and we've seen over the past six months that that's possible. But you really want to see participation from all parts of the market in order to create a healthy sustainable rally.
And what we've seen is that the breadth has been improving, pretty significantly since the bottom. But only recently we've seen it really expand to the level that's going to provide a significant tailwind we think going forward. And granted, this is over the last two cycles, but what you've seen is that when breadth peaks in the marketplace, so last time, in 2013, you had 82% of stocks above the 200 day moving average, and then in 2016 you had 75%.
Right now, we're a little bit North of 80%. But even if we were to trade off of that number tomorrow, historically, it's still taken about two years’ time before the market finds its peak. So, we're very encouraged and optimistic that we've seen this broad participation, and we think it's going to set the foundation for tailwinds going forward. Especially with the addition of the vaccine information that we've got over the past month.
Mike: So sort of tying this together, the things we've talked about so far. If those six stocks are pretty much leading the market and leaving everything in the dust, that is about as weak of breadth or bad as breadth that you can have. The rotation that we talk about getting much broader and incorporating many, many more names is what you see as this breadth improves. And as Doug said, the history is when you get these types of surges, that the value of the market will continue to climb for some time after.
The next slide (side 7) is going to suggest that that doesn't necessarily happen in a straight line. So, yeah, let's do that now, Doug.
Doug: Sure. So, this is just a crowd sentiment poll. So, you know, the market has some contrarian indicators in it, and this is considered one of them. So, as you have optimism building in the market by participants, from a contrarian's point of view that is viewed as a bearish symbol. And vice versa, if you had extreme pessimism people see that as an opportunity to be buyers.
So right now, we're seeing that market optimism reach levels that have historically been a little bit bearish for the market over the short term. So, we would not be shocked in any way over the next few months to see a 5% to 10% correction to work off some of that optimism. But I think, barring any unforeseen circumstances, we would see that as an opportunity to be rebalancers of portfolios. And to continue to add equity risk to the portfolio in the places that may become under owned, based on any kind of sell off.
And go ahead, Mike.
Mike: I'm just going to say, just sort of looking at the picture (slide 7) you can see that, although this does not necessarily trace the market. If we put a chart of the market over the top of it, it would be pretty close. And you can see that pretty much every time that the sentiment rises up above that top line it doesn't take too long for it to roll over and let some of the air, that excess pressure out.
And so, as we think about the future, we recognize that on a short-term basis, anyway, the market is pretty extended. And of course, there are lots of forces working on the market right now. But it would not surprise us at all, as Doug was saying, to see a meaningful pullback. But our long-term vision, as a result of the economy, normalizing and having such a broad swath of stocks still well behind, gives us a great opportunity that when these pullbacks occur to look at that as an opportunity to add to our equity risk, as opposed to hiding from this volatility.
Doug: Sorry. I'm trying to flip the slide and it's not letting me. Give me just a second here.
Doug: So let me work on that. Mike, I think the next slide (slide 8), it touches on the aspect of, oh there we go, little delay there, I apologize for that. The idea of low rates going forward and the challenges that's going to create. So I will, sorry now it's trying to catch up here all the button clicks that I had.
So, when we talked about that earlier, the challenge was that a lot of people own a fair amount of fixed income, and they depend on that for income, and cashflow, and the ability to generate that in retirement. We've entered a timeframe where we've seen significant compression in interest rates. I mean, if you go back just almost two years, owning a ten-year treasury, you could have gotten 2.5%, 3%, and now that numbers all the way down to below 1%. And on the very short term, it's even lower than that, cash products basically pay nothing. And your two-year treasury rate is about 15 basis points.
So, as we think about that and think, okay, how is it that we're going to use fixed income effectively. Because the two reasons that you own fixed income are, one, to generate income, and two, to provide balance to your equity risk. So, as we look at this equation, now we have to say, okay, do we add more credit risk, or other types of risks, to the portfolio on the fixed income side? While we're adding equity risk, or more equity risk I should say, to the equity side of the equation. Or are we comfortable maintaining a healthy amount of solid high quality fixed income assets as a balance against that equity risk, knowing that it's going to resolve in probably a decrease in income generated from those assets. And I think it's probably a problem that's beyond the scope of the time we have left today. But I think we want to start to get that idea in investor's minds and at least comment on it.
So, Mike I've kind of laid the groundwork for this. What is it that you see as the biggest challenge for fixed income going forward?
Mike: I guess the first thing I'd like to do, just briefly, sort of restate the people in our investment committee are tired of hearing me refer to ballast as being, you know, the right amount of ballast keeps the ship upright, too much balance, and the ship sinks. So, the objective here is to use the fixed income for just the purpose that it is in the portfolio. So, traditionally, when we talk about allocations, the least common denominator or the simplest discussion we have before we get into various individual asset classes, is stocks, bonds, and cash. And we talk about allocations as being 70, 30, 60, 40, and so forth and we're always talking about stocks and bonds.
The way the teeter totter has worked is interest rates have declined, we have enjoyed above average fixed income returns over this period of declining interest rates. But as interest rates get to zero there's generally very little or no place for that to go. And as the economy begins to improve over the next year or two, we would expect interest rates and potentially inflation to return.
So, the risks associated with buying the types of bonds that take those sorts of risks in order to get higher yield at this point does not work for us. At least while we're in this period. Until the vaccines are out, COVID is being eliminated, and the economy is recovering. At this point it makes sense to us to keep this level of ballast in the portfolio, even though the bonds are essentially nonproductive, or borderline, I shouldn’t say they're nonproductive. They do have a yield, but after possible inflation and so forth, it's borderline nil.
However, we don't want to effectively create a portfolio that is a hundred percent equities when we have sentiment as extended, we showed you the sentiment chart, and all these forces. Forces, meaning, the government and all the stimulus trying to get the economy rolling again, that would have the force of raising interest rates. And we all remember our teeter-totter rising rates on one end means bond prices going down on the other. So, for the time being, this is where we need to be, but expect us to be introducing similar, but slightly different asset classes once we clear those risks.
Doug: Thanks, Mike. So, this is kind of the summary slide (slide 9). Before we get into brief Q and A here because we're buttoned up against time. But I hate to call this the 2021 market outlook because obviously if 2020 is proved anything it's that things can change quickly.
But I think the key takeaways from what we've just gone over, on the stock side, we believe that the vaccine progress is going to pave the way for economic reopening and further tailwinds. But we are concerned about extended market sentiment, and the possibility of increasing COVID spread causing a little bit of short-term volatility. On the fixed income side, the fed has pledged to keep rates low, but again, the idea of rebounding global growth could put up with pressure on those long ran rates, and balancing income needs against risk levels is going to be critical, not only 2021, but beyond as well.
So, the big themes that we think are the most important to focus on going forward, obviously rotation, rotation, rotation. So, you have growth to value, large cap to small cap, and US to international. And we've already started to implement those themes in our portfolios. And then threading the eye, the fixed income needle, which we think is a process that's just getting started.
So, we've got one or two quick questions here that we can run through. The first one is a question about a specific stock. So again, compliance does not like us addressing individual stock questions on forums like this. So, I will reach out to that individual, possibly today, most likely tomorrow, and we can have a chat about that specific question.
Another question is what would the PE of the market be if you removed the FANMAG from the equation? That's a good question, and I don't have that answer at the tip of my fingertips, but I will make sure that I get it for you if I can create it and we'll certainly let you know what that might look like.
So, one more question that we can get into, Mike I’ll go ahead and ask you. I don't want to put you on the spot, but I think this is a good question. So, of all the things that you're hearing from a consensus basis, maybe what's one of the things that you keep hearing about that maybe you don't agree with.
Mike: Hm. That does put me on the spot. So, the number one thing, and we sort of touched base on it here, but it's the, what is the acronym, FOMO, I guess, fear of missing out. It seems that I'm talking to people that want to, from our perspective anyway, fight the last war. And that is, get on board with those big name growth stocks that are household names. And we have no doubt that those companies are going to continue to do well. It's just that when we look at them through a statistical lens, they're sitting in a place that is almost impossible. If we were going to take a stats class, teacher would say, “things don't live in the natural world out there for very long.” And a quote that I think we used in one of these calls from John Templeton a long time ago that, “some of the scariest words are ‘this time it's different’”. It's not different, those extreme valuations will be normalized. So, that would probably be the thing that sticks out the most, just as a reaction to that.
Mike: I did have one question sorted over to me, based on my opening comments. I said something about taking things into consideration, and we're going to have some planning ideas going out just as a final on that here in the next couple of days. And I said that that should be considered, I think I said something like, in your year-end tax and wealth transfer planning. The question is what is wealth transfer planning?
And so the answer to that question is, many families will at the end of the year, think seriously about charitable giving or, making gifts within their family. So, the timing of that, when you come across years where there is the possibility of having significant changes in the law, in this case, particularly estate and gift tax laws, that would be something to consider. As we indicated that the chances of the Democrats winning both seats in Georgia are slim, but they're not zero.
So, in a way I'm suggesting to people, if you're sort of struggling with the decision and you're looking for a tie breaker, it probably makes sense to move things into this year. Although we think the risks are nil. I was on an AICPA conference call earlier in the week. And the political experts there for the AICPA were suggesting that because of the makeup of the Senate, even if the Democrats do win both seats in Georgia, it is highly unlikely that we will see some of the sort of draconian changes that were being offered during the campaign. Where state tax exclusions would be set back to 2009 levels, and things of that nature, and that corporate taxes would be driven 50% higher, and the capital gains taxes would be doubled. Those things are unlikely to occur no matter who's in control.
But again, as a tie breaker, better to play it safe than sorry.
Doug: I think that's all the questions we have. So, if you want to go ahead and wrap us up.
Mike: Okay. I think we're pretty close, a little over 30, but not by a lot. So, thanks everybody for participating in our call today. Unless news breaks, and if news does break, we will schedule something. But if not, our next call will be in the new year. And as always, if you have any questions between calls, feel free to reach out to your advisor. We're here, ready, willing, and able to help. And that also goes, if you know somebody, have somebody you care about that could use a hand, we would definitely want to be there to help if we could.
That does it. And since I guess this wraps up for the holidays, Merry Christmas, everybody. Thanks for participating. And bye-bye, we'll see you later.