Why is the traditional 60/40 balanced portfolio currently the hottest topic on Wall Street?
Is stagflation a real thing?
Why is Glenn using salty language in the office?
Maybe we should curb our enthusiasm about the economy.
Listen in as Royal Harbor Partners Glenn Royal and Natalie Picha discuss all of these important questions.
Welcome to RHP Market Talk. I'm Natalie Picha.Glenn Royal:
and I'm Glenn Royal.Natalie Picha:
and together with Michelle Jones, we are the founding partners of Royal Harbor Partners Wealth Management. We have a lot of ground to cover today, but first I'd like to say, thank you Glenn for your service, as we're recording today on Veteran's Day.Glenn Royal:
All I have to say to that is, Go Navy.Natalie Picha:
Yes. For any of our listeners that don't know , Glenn is a Navy veteran and we're just very grateful for his service. And his experience in the Navy has brought a lot to RHP.Glenn Royal:
A little salty language, maybe. I'm not sure otherwise.Natalie Picha:
Occasionally, maybe. So today we're talking about the traditional 60/40 balanced portfolio and the potential risks associated with this very, very common strategy. Goldman Sachs recently put out a really great research piece on this topic. And what we know is the monetary and fiscal policy response to the COVID-19 crisis has allowed for an amazingly sharp recovery in economies and markets. But we believe this could have a long lasting implication for both the 60/40 return and portfolio risk overall. And so that's kind of where we want to, want to go today. I know everybody else is talking about it and sometimes we'd like to pick up these topics and talk about them also. I'm just going to kick it off with this question. Why is the 60/40 balance portfolio such a common strategy? It seems everyone has a 60/40 traditional, right? That's what you hear out there. And we also are a planning based practice. So, a lot of our clients are in balanced portfolios. Why don't we talk about 60/40's?Glenn Royal:
Well, Natalie, that's a good question. Thank you for asking that. The 60/40 portfolio also known as the balanced portfolio. All we're simply saying is 60% stocks, 40% bonds. A balanced portfolio. And in our wheel of investment choices we have three varieties of that, you know , 60/40, and then 70/30, and an inversion of 60/40 bonds of stocks. The reason why I think this has worked so well is if I go back , 40 years now, the 10-year treasury, in September 30th, 1981 was yielding 15.84%. Exactly. And since that time, what's helped the balanced portfolio out the 60/40. So well, as you've had good economic growth, the benefit equities at the same time, you've had this secular decline in interest rates. So we've seen interest rates go from 15.8%, 40 years ago to 1.55% today on the 10-year treasury, that's been the fuel to l ift this bond market where we've had extraordinary returns this last four decades.Natalie Picha:
Right? And not to get too elementary, but wanting to make sure that, all of our listeners understand, when we talk about where those interest rates were at 15.84% and the correlation of interest rates to bond values. So, when we say we're in a bear market in bonds or fixed income, what that means is as the interest rates come down, the value of those bonds, actually goes up. But we're now in an opposite situation, right? Interest rates are going to go up. Those bond values are going to go down. So, that 60/40 portfolio, that 40% of the fixed income or the bonds was supposedly your more conservative, less risky, piece of your portfolio. That may not be the case going forward.Glenn Royal:
Yeah, that's something we've shared. Our concern is that the safest part of your portfolio is your bond portfolio. And that may not be the case right now, because of a situation where interest rates are zero. You've got an economy that's recovering with all the central bank stimulus. And that starts to put pressure on rates going higher. And remember, I use the picture...I want everyone to do this right now in your mind...we're on radio here. I get that. But, I want you to put your arms out by your side and do the inverse. It's like a see saw. When bond prices go down, yields go up and when yields go down, bond prices go up. So, get that in context, we think of bonds mainly, generally about the income they provide. Right ? There is a price action as well. Right?Natalie Picha:
So, with the research that we're reading, what we're seeing in that 60/40, again, I'll go back to the planning side, right? We talk about figuring out for a client, what their goal is. And what their risk profile is. And generally speaking, somewhere in that balanced portfolio, we know we've got to , we're going to take this much risk for return. We're going to offset that with some conservative piece. But in the research we're seeing , is there a potential to lose your balance between stagnation and inflation in the 60/40 portfolio? What does that mean?Glenn Royal:
Yeah. So stagflation is something that's entered the press lately. I've seen it more. We do have the ability to track terms when they hit the press. And see the spike in them. And stagflation just hit the last month or so it's all over the map. First of all, I don't think we're currently in a stagflationary environment. All that simply implies is that you have slowing earnings growth. Slowing growth in the economy. Stagnant growth, which is generally where we've been the last decade, about 1.8% GDP growth. You get two or less, that's kind of stagnant growth. It's not enough to increase our real standard of living wages, that sort of thing. So, you have stagnation. Then you top on inflation. And that's what we had back in the early seventies. We had this period of high inflation. It was stagnant economic growth. Coming off of the booms of World War II, the fifties and the sixties. That we saw. So, that's, that's a fear out there. That's obviously not a good investment environment to walk into, right? So that's being bandied about. But I want to point out right now, this in 2021, because of the effects of central banks pushing so much stimulus in the system, our growth rate is coming right at 6% this year. Again, that's 1.8% was the average prior to the pandemic. If next year, I'm looking for that growth rates to still come in at 4%, we still have a very strong economy. Which counters that argument about the stagnant economy. Of the stagflation. We are seeing inflationary pressures, but we still see good growth in the economy. Wage gains. Things of that nature that are able to offset that growth.Natalie Picha:
That's a great point. I guess the question comes back to, cause I know we just had an inflation print that came in really hot. Right? Is it transitory? That's a whole other term that just keeps hitting the press. Transitory. Transitory. Transitory, is it transitory?Glenn Royal:
Boy if anyone can define that for me. What that means. That would be great. No one really quite knows. You know, and that's part of the issue with the 60/40 that comes into this balance portfolio. Is we're in a situation where central bankers are holding down the federal funds rate. They're holding down short-term rates. Monetary policy. Making it easy. Financial conditions are very, very easy. Which is fled into the equity markets and risk assets. Had this big boom. What we're seeing there, which is very interesting and it's got us a little...it's an odd occurrence. But the federal funds rate. If I take today's federal fund rates , which is in a range of zero to a quarter percent, and I subtract that 6% inflation. I have a federal funds rate that's a negative real rate at 6%. Negative 6%. We' haven't seen it . You've got to go back to the seventies. Early seventies. So, the market is picking up on these things, underlying it. And one thing I want to really impressive about the 60/40, the risks that we see, is that with this fed that's artificially pressing things down, as they start to come off of low rates. And start to normalize the process. They're being forced, because the inflation hand. Right? At 6%. That has, when we, with the basis of a 10-year treasury paying 1.4%, I have a very low yield cushion for bonds to give me the traditional offset to risk that stocks had. If I go back to 2008 and the 60/40 portfolio, my yield was 4%. Yeah . Today is 1.4%. So I don't have the cushion of higher interest payments to come in. That has us concerned going forward. It has to do with the growth and the inflation mix and the economy. So, right now we've got strong growth, strong inflation. You expect the fed, it's going to start to eventually, you know , stop refilling the punchbowl. As I like to say. They want to tell them to tone the party down, by starting to raise rates. That has some pressures, just naturally, that we're going to see in the bond market. Rates are going to go up. So, we're not getting a yield again to offset that fixed income. And that's the concerns that's really going on all over Wall Street. The big question is, you know, I'm looking at GDP growth to go from 6%. And then I see it going down to 4%, next year in 2022. Consensus estimates. And then at 2023, it's back to 2.4%. So, a lot of what we're having right now, is... It's the consequences of the Delta Wave that came on, COVID. That bled into logistics, that bled into labor. And these weren't things that economists were forecasting. Well, we didn't know about the Delta Wave when this first came upon us. My question that I have is, how high will rates actually go. If I'm back to 2% GDP growth, 2.455 and 2023? Are we actually returning back to that secular stagnation, which is another way of saying, you know, slow GDP growth, less than 2% with just not a lot of gain in the economyNatalie Picha:
To where we were before COVID.Glenn Royal:
Goes right back to the FANG stocks. Right? The big tech, secular, earnings growers.Natalie Picha:
Well, and so that takes us right to the topic of elevated valuations. Right? So, the pressure in the market, obviously on the 60/40, with the interest rate environment where it is. But we've also got some pressure here because, in one of the reports I read, it said, you know what, well , why not just go all in for equities. If all of a sudden the 40% part, you know, that you consider your more conservative part of your portfolio, is your safe part is now not so safe. Well, that just means it's go for more equities. But look at where we are in valuations today.Glenn Royal:
Yeah. Yeah. You can look at it, you know, 50 different metrics on valuation. All of them are showing , richest it's ever been. Right? As a consequence of the central bankers pushing money in the system. So, that is something that I think we have to be cautious of. I wouldn't go all in, all equity. If I had a balanced portfolio approach today , we're taking, our look at it is this way. We still need fixed income. It serves its purpose. It's a preservation of capital. It is a risk offset. If we have a risk off event and equities, it's still gonna stay and hold is core value. We're just not making any money. Particularly money, a real rate of return above inflation. That's the downside to it. But it serves that purpose. And it does produce cash flows, et cetera. What we're having to look at in this low rate environment ,with rich evaluations and equities is, stepping up, perhaps, the studies we're doing here is in the private markets. Not the public markets. So, we can go out and buy Tesla, and 10-year treasuries all day long in the public markets. The last 20 years, 30 years have seen explosive growth in private investing. In private equity. Private credit. All these number of things that we see. And that's an area that we think that we can get, the term we call carry , which is basically interest rate, interest payments to us while we're waiting for this market to kind of reset its valuation. And that's what we'll be looking to . I do see, you know, 4% growth is great next year. But it's that slowing rate of growth. So, I've got probably a greenlight through the mid-part of next year. And then we're going to be addressing, as we go from 4% to 2% in the second half of the year. A nd with the equity valuation so high, you can argue that it's p ulled forward some returns from next year, from the stock market. So, we're looking at a year...and I want everyone, you know... earlier this year, we had p odcast f rom January... Contain Your Enthusiasm. We were so excited about the year. Y ou k now, hey, that's worked out well, r ight? B ut now, you know, the t heme is Curb Your Enthusiasm, right? We want you to be a little bit more realistic about return expectations, going forward. A nd one of the ways I'm going to probably get that, is going to these private markets. Where I'm capturing the $50 to $75 million revenue businesses, that are growing. But they're not yet at the public markets. They just, haven't g ot to that p hase. Maybe they don't want to go public. They want to stay privately held. So, that's an area where we're seeing a lot of opportunity. The t rade-off with that is liquidity. So anything that we do pair off into the private space, these are private investments. So, you put your money in it. It has t hat time to incubate. And before you get that return back. So, there is a little liquidity l ot. That would be one reason why we would want traditional bonds and traditional stocks in that portfolio to provide t hem liquidity offsets and things we need.Natalie Picha:
Okay. So, what about certain stocks providing an inflation hedge? What are your thoughts on that? Because again, we're talking about 60/40. We're still, you know, we're thinking about all the ways that a traditional 60/40 is going to react to this market, as we move forward. And ways that we can continue to perform. And stay, what I would say, in the right risk model, for a particular client's goal. So, what about stocks, as an inflation hedge?Glenn Royal:
Well, they traditionally are. I mean, not necessarily when the inflation first comes on the scene. Everything has to adjust for that. All asset classes. But stocks that have purchasing power. Pricing power, which is what we've talked about. We want price makers in the portfolio, not price takers. But the ability to set their prices and had to go through. So, in our portfolio, we have , producers in the consumer staple areas. Archer Daniels, Midland, and Bungie that are in that commodity place, o f food commodities. So, commodity based companies. Energy based companies. They are companies that have the ability to raise their prices. And w e're t here. Now, some of the others, a little bit more sticky. If I look at something like, tech stocks, in general. Not, not your Facebooks and Amazons, that make money. I'm talking about the companies that are all on the come. The promises they're g oing t o make money. They're fast growers. 30% growers. Just doing all the good in the world. Wall Street throws money a t them. A nd people like it. But those are companies whose valuations are sky rich right now. That's the group we're worried about. Those are considered long duration assets. They're not paying us anything today. But that expectation is in the future. Those are the stocks that w ill have pressure. As we come into a rising rate environment. We saw that a little bit earlier this spring when we had some sell off in tech. So, that has us going back into the old smokestack economies. D ell, industrial, the materials, those types of companies that have pricing power can raise it. You're seeing it in a number of chemical stocks right now. They're able to pass those prices through. And this earnings period, that just came through. Which was, again, this market is being driven by earnings. Margins a re at 15% earnings growth. Would be expected in the third quarter to come in at 28%. Growth came in at 40%.Natalie Picha:
That's an amazing number!Glenn Royal:
It is It just keeps exploding. As long as we had this earnings growth. I think this market is bid supported. It's when that earnings growth starts to slow, with the fed that's coming off of easy money that that's when things started getting a little dicey.Natalie Picha:
So, great segue way right into this question. And you've lived this. I mean, you've seen the markets up and down for, well over 30 years now, knowing where we are evaluations and what you just said. What about equity? Bubbles?Glenn Royal:
Yeah, so you know , I lived through the dot com. And that was an era of those long duration assets. They had no money. You know we were justifying their valuations by, it shows you how silly we can get some times, but we were justifying a company's valuation by how many clicks they got on their website each day. That's how extreme it got. So, is there some parallels in today's market, with extremes and different stocks, meme stocks. Absolutely. It's all over the place. Deja vu. It just rings in my head. That's why we're trying to avoid all that stuff.Natalie Picha:
We've been there. Been there, done that . Okay . Well, do you see one on the horizon then? I mean, if you want...Glenn Royal:
Yeah. So it's not a general bubble. And again, if I go back to the dot com , you were, it was a technology media and telecom companies. They were the bubble. It wasn't energy. It wasn't healthcare. It wasn't financials. There were so many other places you could go. Value. Value stocks in general value managers were shutting their doors down. They were going out of business because, we were in a new paradigm. This Internet's going to make everything go, go, and we'll never see a bear market again. It was a whole different mindset. So, there's shades of that that's going all around right now. And I'm cautious of that. So, in that environment, as a portfolio manager, do I chase performance? Or do I take the tack that, we see things over valued , saying which we're concerned . We're not willing to chase performance for an extra two or three percentage points. We're going to hold back. Yeah. So, that's kind of our stance. We're being a little bit more sober-minded about the market right here.Natalie Picha:
Right. Well, for our listeners out there, you know that we love, love, love to talk about this stuff. You're always welcome to give us a call. We've got all the research, that you could ever want. Probably mind numbing , to some extent.Glenn Royal:
After you hear these podcasts and hear me talk. I'm pretty sure it's mind numbing.Natalie Picha:
Do you have any other things you'd like to throw out there about this topic today? In the 60/40 portfolio.Glenn Royal:
You know , the one thing I do want our listeners to be aware of is that, whenever these topics, 60/40, whatever, it may be. Whenever it leaps from the investment research department, over into the marketing department. Be a little, you know , cautious on it. And that's what's happening. Every marketing department. Investment fund company in the country is addressing 60/40 right now. And they're all trying to push you into different assets and things of that nature. Just be a little cautious with that. You know, Wall Street is here to sell you product. Whether it works or not. Yeah. Different story.Natalie Picha:
Well, and I'll just add my 2 cents. Call us. Right? Let's have a conversation. Because sometimes what you hear out there is, not the whole story. So , I like to say, just give us a call. We're happy to help. So, thank you to all of our listeners for listening to Royal Harbor Partners Market Talk. At RHP, we are passionate about planning for your financial future. We are devoted to our relationships with multi-generational families, for the creation of successful legacies. Through our one-on-one conversations, we can help you navigate your personal wealth management and investment journey. How different will your life look with the right advice? Call us today, or visit our website www.royalharborpartners.com to start your conversation.Disclosure:
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