The Fed and the Markets Face Multiple Headwinds with Brad Kasper

The Headwinds Facing the Fed and the Markets

[00:05:03] Brad Kasper: I think we are as well. At the beginning of 2022, we released 2022 market outlook. In there, we addressed four key headwinds facing the markets and the Fed. The first headwind was supply chain issues, which were still running hot. Those also tail into the inflationary pressures, which has grown dramatically. Next, we had concern about the Fed’s ability to achieve a soft landing. I think that language is a little bit obnoxious. What does soft landing really mean?

[00:05:41] Dean Barber: It means they’re a good pilot.

[00:05:42] Brad Kasper: Yeah. We talked about slowing economic data, not specifically GDP, but data in general. We’ve seen a softening of economic data across the board. Then, there was the COVID concern that we had. It was the zero-tolerance COVID policy out of China that had a lot of people worried.

I know all these seem slightly unrelated, but they all kind of feed on each other. Those same headwinds that we addressed at the beginning of the year seem to have been on steroids since then. They just compile upon each other.

The Fed’s Ongoing Fight Against Inflation

[00:06:16] Brad Kasper: So, what does that mean? Well, the Fed came in and inflation is running hot. Inflation is at 9.1%, which was even higher than the 8.8% they were looking for. So, we came in a little bit hot, which is another year over year miss on wildly high inflation that we haven’t seen since the early 1980s, as we discussed earlier. So, the Fed’s in a tough spot, right? The Fed must step in here and try to slow this overall economy. And the Fed is doing so by raising the Fed funds rate, which quite frankly, we think got away from them at the tail end of 2021.

[00:06:50] Dean Barber: The writing was on the wall that inflation was heating up. The Fed should have started raising rates last year. I think the important thing for people to understand is why are bonds doing what they’re doing? The 10-year treasury started the year around 1.5% and has been as high as 3.5% in 2022. It’s just slightly under 3% as of mid-July. We’ve got a steeply inverted yield curve now, which generally points toward a recession.

If you own an individual bond, you know what you paid for the bond. You know what the value is going to be at maturity, and you know what the interest rate is. So, you can calculate your yield to maturity if you hold it to maturity and know what that return is going to be.

Understanding Bond Duration

[00:07:42] Dean Barber: But in the meantime, most people that don’t own individual bonds may own bond ETFs or mutual funds. They need to understand the duration of that ETF or that fund. I’m going to give an example of a specific fund here and maybe a few more later, but we’re simply highlighting them to help you understand the principal rather than making recommendations. Please talk to your investment or tax professional before making any financial decisions.

Using bond AGG as an example, I think the average duration is like six and a half or something like that. That means if you get a 1% rise in the 10-year treasury, you’re going to lose 6.6% in the value of that bond. Well, we got more than a 1% rise. We got so much of a rise that at one point, I think the bond AGG was down 12.5% this year.

[00:08:19] Brad Kasper: Right. When the Fed starts moving interest rates, they only control the short end inside of the Fed funds rate, the short end of the curve. The rest of the curve—the 10s, 20s, 30s—will start to adjust based off the interest rate movements that the Fed is doing. The fact that they started to expedite that movement suddenly puts greater pricing pressure within the 10s, 20s, and 30s. Look at 30-year mortgage rates now.

[00:08:44] Dean Barber: I know, almost 6%.

[00:08:45] Brad Kasper: Yeah. It’s jumped over 2.5% since the beginning of the year. Suddenly, that home that you wanted to buy just became a whole lot more expensive if you’re going to borrow on a 30-year loan. Same thing with a 10-year bond. As these rates go up, it puts pricing pressure on them.

Can the Fed Get the Overnight Rate Back in Check by Year’s End?

[00:09:04] Dean Barber: Here’s the question, though. I want to go back to the Fed and to the overnight rate that Brad talked about. That’s the short end of the curve. What are the chances that the Fed gets to its 3 to 3.5% overnight rate by the end of the year. That is what they’re talking about, but we don’t see more upward movement on the sevens, 10s, 20s, and 30s.

[00:09:32] Brad Kasper: Then, you’re just pushing us right into recession. You’re going to invert the yield curve even more dramatically than it is today. And maybe that’s OK. Maybe we’re already in recession and the Fed has a little bit of room to continue driving us into it. But I’d be careful with some of that.

First, the markets are trying to price in six to 12 months in advance at any point in time. They priced in that 75 basis point movement of the Fed funds rate we just in July and probably another potentially 75 basis point jump in September. If that plays out, that’s going to put us pretty darn close to that 3% target that they’re looking at. Between now and then, what kind of action are we going to get on the 10-year treasury? If it continues to collapse, I’m going to argue that it backs the Fed in a corner and the odds of more 75 basis point rate hikes start to go down.

Looking Back on the Fed’s Journey in Recent Years

[00:10:29] Brad Kasper: I figured we would have the Fed funds rate hike we had in July. But if we see a softening of inflation, I think the Fed is going to cool its stance a bit. I don’t think the Fed is going to get out of the game of continuing to try to normalize. Jerome Powell was on a great path to normalization before COVID hit. In 2018, we kind of hit the high of that normalization process. We watched the twos and the 10s get darn near close to inverting. The Fed stepped in and said, “Hey, we ran too far, too fast. We got too hot.”

[00:11:00] Brad Kasper: And what did the Fed do? In 2019, they were cutting rates going into 2020 when COVID hit. We went to zero interest rate policy. I shared that because there’s a lesson that I think Powell probably learned during that timeframe. There’s a balancing act of not just killing the overall economy. But the difference between now and 2020 is a 9.1% inflationary print that we’re dealing with. That needs to be the primary mandate of the Fed.

And Looking at What Could Happen in the Bond Market for the Remainder of 2022

[00:11:28] Dean Barber: That’s right. I guess my question is, what is your outlook for the bond aggregate for the balance of the year? How do you think that plays out? Because the yield’s not great yet. Quite honestly, I can go buy a one-year treasury and I can get a better yield than buying a bond aggregate.

[00:11:51] Brad Kasper: I think the Barclays US bond Agg ends the year better than where we’re at right now. There is a benefit of that coupon clipping along. If we can just get some stability out of the 10-year, which I think we’re starting to see. We’ve been up to as high as 3.5%. The last two times, we’ve been up to 3.25% on a 10-year. And it starts to hit this pretty strong resistance level and tends to find its way back down. I don’t think it’s going to break above that 3.25% until we get some clarity of how far this Fed is really looking to run. And right now, I think the bond markets are pricing in that the Fed need to stall at some point within the next couple of meetings.

[00:12:29] Dean Barber: And that’s because of the slowing of the economic activity.

[00:12:32] Brad Kasper: Slowing of the economic activity.

Inflation Is Still the Fed’s Main Concern

[00:12:35] Dean Barber: But again, where I am concerned is that the inflationary numbers. The pure inflation itself is harming most Americans far more than a bad bond market or a bad stock market is harming the wealthy people. It’s causing them to not be able to do the things that they want to do.

Discretionary spending has declined substantially over the course of the last several months. The Fed needs to be aggressive to kill inflation because as we know from the late 1970s, early 1980s, you can have runaway inflation with a stagnating economy for a long period.

And What About Stagflation?

[00:13:17] Brad Kasper: Yeah. And there’s a scenario where stagflation plays out, right? The probabilities of it are still low at this point, but they seem to be increasing every month. But let’s go back. The Fed has a primary mandate. It’s to protect the value of the dollar and keep inflation in check. The Fed has a third kind of loose mandate to make sure they keep unemployment in line to some degree.

[00:13:40] Dean Barber: Two of those things the Fed is doing a pretty good job at.

[00:13:43] Brad Kasper: Yeah. Unemployment still looks very good, which is why I think you’re going to get a lot of banter that goes back and forth. If we get a negative GDP print here in second quarter, which would be the textbook definition of a recession: consecutive quarters of negative GDP growth, I think the narrative that’s going to come out by a lot of economists and market specialists are going to be, “Yeah, this isn’t a real recession.” Well, you can’t move the goal posts on the definition of what a recession is.

Remembering the Definition of a Recession

[00:14:12] Dean Barber: I read something about that here in early June where somebody was saying, “Well, even if we have negative GDP, this isn’t going to be a real recession because people are still doing well, we have low unemployment, and you can’t have a recession with low unemployment.” And it’s like, well, you can still have negative GDP growth, which is the definition of a recession.

[00:14:32] Brad Kasper: If you go through their core thesis with all this, this recession is not necessarily an overheating of the economy. It’s the sheer amount of money that we’ve pumped into the system over the last decade. And to that point, I get it. We’ve addressed it before. There’s a scenario where if you were to remove the backstop of the Federal Reserve and the massive amounts of money that they’ve pumped into the bond buyback programs back in 2020, if you start to remove the stimulus checks that everybody was getting during the pandemic, where does this market go? We’re seeing it, right?

[00:15:13] Dean Barber: Right.

[00:15:13] Brad Kasper: When you dry up some of that capital, suddenly reality starts to set in. We were looking at some of the PE ratios. It can’t be clearer than that.

This Is a Different Scenario Than 2008 and 2020

[00:15:25] Dean Barber: And again, I don’t want this to come across the wrong way, but during the pandemic and following the pandemic, it was almost like the United States was becoming China. The U.S. was thinking that the government was going to control the statistics of the economy. And that simply can’t work. Like it or not, consumer spending is still 70% of our gross domestic product. Between corporations and government spending, that’s only 30%.

The government can’t spend enough money or do something to control the economy. Now, they were successful in bailing out companies and industries back in 2008. They were successful in stopping the bleeding in the bond market and the stock market during COVID. But when you’ve got inflation running as hot as it is, they can’t just keep funneling money into this thing.

A Medical Analogy to Explain What’s Going on in the Markets

[00:16:18] Brad Kasper: These have been like shots of morphine to the economy. But the problem with shooting morphine is eventually it’s going to wear off. So, did you fix the actual pain point that you had in the first place?

Go back to 2008. That was the original TARP and TALF, the bond buyback programs that were literally being written in midair to kind of bail us out of the financial crisis. And then in 2020, we dusted that playbook off, jacked that thing full of steroids, and went at it. And it did. I’ve never seen a recovery as quickly as we should have seen back in 2020. Think about that.

[00:17:01] Dean Barber: I know. It’s insane.

[00:17:03] Brad Kasper: Well, compared to today. I get that this time feels different. We’re now six months into this drawdown period. There’s some investor fatigue that’s playing out. But the reality is the depth of the drawdown in 2020 was 35% on the S&P 500. We’re roughly at 20% right now. There’s another potential 15% to go to even get back to what we saw in 2020.

I use that as the example because in 2020, we shot ourselves up with that morphine and had one of the fastest recoveries I’ve ever seen after a 35% draw down in the S&P 500. And now we’re dealing with the aftermath of it. We need either more morphine or allow those wounds to heal. Those wounds are pretty darn deep and we’re learning they’re deeper than a lot of people had thought.

We Have a Spending Problem

[00:18:00] Dean Barber: Yeah. I know we did. I’m going to be facetious here for a minute. What do you think would have happened if Biden’s $3.5 trillion stimulus package would’ve passed?

[00:18:10] Brad Kasper: I think it would’ve crippled our economy.

[00:18:14] Dean Barber: I think the inflation would be even worse.

[00:18:17] Brad Kasper: Absolutely. And in all fairness, I think even under Trump and the massive amount of stimulus packages then … It’s not necessarily a party thing. We have a spending problem. And unfortunately, we’ve become prone to leaning on it every time we find ourselves in trouble. But guess what? The backstop is gone. The Fed is finally allowing the balance sheets to unwind during this timeframe.

These are all tools that should slowly start to help cool inflation. But what we don’t know is how long it’s going to take. The only cure to high prices is high prices. Eventually, things get so expensive that we’re going to say, “I’m not buying that. It’s not a need at this point. I’m focusing on what I need, not what I want.”

When a Supply Deficit Becomes a Supply Surplus

[00:19:04] Brad Kasper: When that starts to play out, there’s going to be a change in terms of what used to be a supply deficit becoming a supply surplus. Suddenly, the costs of goods at these brick and mortars— Walmart, Target, Costco, etc.—will start going on sale. There will be bigger things where they need to empty off their shelves.

These are all healthy signs that we’re starting to see early stages of. But you know as well as I do, it can take years to work through some of these things. What I’m fearful of is if you look at the last 10 years, every time we’ve had a market sell off or drawdown in the marketplace in the last 10 years, it’s been followed by a wildly rapid recovery. If we sit here and wait for that same pace recovery, I’m afraid we could be sitting here waiting for a while.

[00:19:52] Dean Barber: But remember why we had those rapid recoveries. It was because the stock market was addicted to the morphine that the Fed would provide. They would just go, “Oh, things look bad. Let’s throw some money into this.” They can’t do it this time.

The Fed’s Difficult Lesson to Learn

[00:20:10] Brad Kasper: Yeah. They can’t. I mean, not if they want to go and tackle what their primary mandate is. That’s why I go back to it. I argue that when you start doing the TARP and TALF back in 2008 and then you do it again in 2020, suddenly it’s like you’ve added an additional mandate of controlling or suppressing market volatility. That’s not the mandate of the Fed. And they’re going to learn this lesson the hard way.

That’s one of the things that I’ve been harping on. A little over a year ago, Powell did that 60 Minutes interview. He was wildly confident in the Fed’s ability to control inflation and manage through whatever turbulent times that happened to be around the corner. I said afterward that anytime there’s that much conviction in your ability to control something that’s so wildly out of your control, you’re going to have problematic times around the corner.

[00:21:06] Dean Barber: Well, that’s no different, though, than former Fed Chairman Ben Bernanke in 2007 saying that Fannie and Freddie were safe and that there was no mortgage crisis, no loan crisis. He spewed that stuff all the way up to the end of 2007. I think it was even into mid-2008 before everything fell apart and Lehman Brothers went bankrupt.

[00:21:33] Brad Kasper: Absolutely. We had to bail everybody out and pump money into the system. I hope this doesn’t come off like I’m bad-mouthing Powell’s job. I wouldn’t want his job as Fed chairman in a million years. I’m not bad-mouthing what Bernanke was doing. These are very difficult things to see and predict. These are wildly bright people with the pulse on what’s going on, and guess what? If they’re getting it wrong, what else is wrong at this point?

Markets Don’t Like Uncertainty

We started this conversation by mentioning the headwinds that the Fed and markets are facing. What the markets really don’t like is uncertainty. But let’s look at the other side of this conversation for a second. What if I were to add Russia and Ukraine to Fed’s and markets’ list of headwinds at this point. What if Russia and Ukraine came to the table tomorrow and suddenly we have a conflict that has an end in sight? Markets are going to react favorably to it.

[00:22:29] Dean Barber: That’s not going to happen.

What Can We Learn from PE Ratios?

[00:22:30] Brad Kasper: What if inflation were to come in and it was 8.5% today versus the 9.1% that we saw? Markets are going to look at that and say it’s cooling. They’ll say that transitory statement held true. But it was just about two years late. So, we’re one good news cycle or a little bit of clarity away from markets being able to settle in a little bit. Before Dean and I started this podcast, we had been looking at some of the PE ratios of big stock names right now.

[00:23:00] Dean Barber: Yeah. We have them right here. Let’s do this and use Tesla as an example. Tesla stock is down 50% this year. So, the question is does that make Tesla a buy? Is that a good thing? Well, Tesla’s price earnings ratio is still at 96.9 as of mid-July. Amazon is off 50% this year and their price earnings ratio is 53.6.

Based on what Tesla does, how they do it, and how rapidly they’re going to make vehicles, etc., they’re probably at least 50% overvalued at this point. To get them back to fair value, even a PE of 50 for a company like Tesla still could be a little bit rich. A PE of 53.6 for a company like Amazon is still too rich.

Is the Bottom Already Priced In?

[00:23:56] Dean Barber: So that means that there’s room on a downside for these things to go farther. Go back to 2008, and even more importantly, back to 2000-2002. We’ve put out a chart many times that shows fair value and then where the markets are. Most of the time, the markets are above fair value. They spend way more time above fair value than they do below fair value.

But when you get into a negative market cycle, you’ll typically see not just a reversion to the mean, but below the mean. So, you could get those market valuations to go below fair value. You get into the market valuations where they’re below fair value. Now, it’s time to start buying. But I think you need to have caution between now and that time.

[00:24:51] Brad Kasper: Yeah. And the question I get all the time, “Is the bottom already priced in?” Well, who knows? The reality is that there is a lot further that some of these names could go to get back to.

[00:25:03] Dean Barber: And they make up a huge part of the S&P 500. They make up a huge part of the NASDAQ.

How the S&P 500 Has Changed Over the Years

[00:25:07] Brad Kasper: And I think that’s what’s so dangerous. Right now, about 26% of the S&P 500 is represented by big tech names. These indexes have been skewed. If you were to go back to 2001 and look at who are the top 10% or top 10 holdings in the S&P 500 in 2001 versus today, it’s very different. It was very much value-oriented names back in 2001. In 2021, it’s all tech names.

There’s been a massive rotation and there could be a natural shift that’s taking place here. But at the end of the day, I’m not here to debate if we go down another 10, 15, 20%. We very easily could. We also could have already priced in a bottom. But what I will debate is when you start to get to these levels, going through the exercise of knowing who’s cheap, who’s expensive, the ability to separate good names and bad names through these types of market cycles help control risk within portfolios.

When Is a Good Time to Start Stepping Back in?

[00:26:00] Brad Kasper: Not only that, but when you start to see interest rates rise, the accessibility to cheap capital becomes more expensive. So, who has the deep balance sheets? Who has the cash on hand? Let’s use Microsoft as an example. Microsoft has been printing silly money for the last 10 years. And what are they doing with it? They’re buying back their stock. They’re doing a lot of things that are very prudent.

Or look at Google, who’s had a massive sell-off in 2022. A company like that is so flush with cash. While this is painful, people want to know a good spot to start stepping back in. Because these could be very good long-term ideas to explore.

[00:26:45] Dean Barber: Let’s do a few more of these because I think this is very important for people to understand. Microsoft is as close to fairly valued as you’re going to get at 26.4. As big as Microsoft is, there’s still a lot of room for growth and repeat customers. Apple is valued at 23.7. Both of those stocks are off, but those two are probably fairly valued because of the types of companies they are.

Google is at 20.76 on the price earnings ratio. Again, they’re printing money. So, some of those names have gotten down to a point where they could be an attractive buy right now. One of the interesting things is some of the value companies like Procter & Gamble with a higher priced earnings ratio than Apple.

[00:27:32] Brad Kasper: Yeah. What a wild example.

[00:27:34] Dean Barber: That doesn’t make any sense.

Research, Research, Research

[00:27:36] Brad Kasper: It does not. Typically, when you go through these types of market movements, one of the quickest things that a lot of investors think about is finding something that’s paying a solid dividend or high income. And that’s not always a solution. At this point, large cap value is typically the space that investors will go to. They’re down about 12% on the year versus the 20% of the S&P and the 30% of the NASDAQ.

You’re sitting here going, “Well, why haven’t they priced in more? Are they that much of a better deal?” And to Dean’s point, Procter & Gamble as an example, may not have been fully tested through this cycle yet, which may mean that there’s greater downside on the value side. So, those that are chasing income, I hope you’re not getting penalized. There’s just greater research that it comes full circle.

[00:28:28] Dean Barber: Yeah. I was looking at the growth side of things, just looking at the Growth Fund of America. It’s off 30% this year.

Pandemic Darling Stocks Plummeting

[00:28:36] Brad Kasper: Oh yeah. A lot of these names are just getting pummeled. Think about it, though. If you look under the hood of some of those funds, the pandemic darlings—Zooms, Peloton—they’re down 50, 60, 70%.

[00:28:53] Dean Barber: And they should be.

[00:28:54] Brad Kasper: They should be. They got run up, bid up, and had a 10X movement in a period that typically takes a company like theirs 20-30 years to experience.

[00:29:08] Dean Barber: I would love for somebody to come in and value my company at 100 times earnings.

[00:29:12] Brad Kasper: Yeah. The global shutdown was one of the wildest things that I have seen with how resilient the tech space became and the way that we priced it out. There was a ton of money to be made. But at this point, a lot of it is just going right back to the wayside.

[00:29:28] Dean Barber: Yeah. What happened with those names reminds me an awful lot of what happened with the Dot-Com Bubble. You had these companies and that were supposedly going to be the future. They were where it was all going to be. So, the money just goes piling in. But there were a lot of people that didn’t catch the upswing. They were late. The average investor didn’t rotate or go back into those growth names until probably mid-2021 when it was over.

What Is the Concept of Target Date Funds?

[00:29:57] Brad Kasper: Sure. Which brings up a great concept that I think Dean will like. When we think about investing, and if you’re building a model, there was an old concept with the target date funds. Are you investing to or through the target date? When are you really getting conservative? Are you getting conservative the closer you get to it or once you get through that date?

I’ve been thinking a lot about that concept, especially as it involves investing in building models. When you build a model, do you build a model to a market event or through a market event?

[00:30:34] Brad Kasper: If we understand the risk of a portfolio or of certain different asset classes and behavior of those asset classes, we want to know that we’ve tested them through market cycles, so that when we get to it, we don’t find ourselves in this situation where we have to kind of jump ship or make massive changes. Not that it’s not relevant or necessary to do from time to time but building a strategy to manage through events makes a lot of sense, especially when it comes to understanding the risk of those portfolios.

[00:31:05] Dean Barber: I like your concept of discussing the target date funds because I think that makes a lot of sense. I just pulled up one of the target date 2030 funds. And guess what? They’re down year-to-date 20%.

[00:31:16] Brad Kasper: 20%. Yeah.

A Lack of Control with Target Date Funds

[00:31:19] Dean Barber: Yeah. Right along with the S&P 500. Someone could say they’re going to retire in the next seven or eight years and that they need to start getting a little bit more conservative. But I just don’t like target date funds because I don’t think they have enough control. I can’t say that I want to reduce my equity exposure or take my fixed income exposure all down to ultra-short durations. I need to have control there. You can’t have that control in the target date funds. When you look at people’s 401(k) plans, most will have S&P 500 or one of those target date funds.

[00:32:09] Brad Kasper: Yeah. And if they have a bond in there because they’re getting conservative, it’s going to be a Barclays US bond Agg-esque type of a position. Which by the way, didn’t help you, right?

[00:32:18] Dean Barber: Right.

[00:32:19] Brad Kasper: And this is where I think the big rub is in 2022. The second quarter is complete. We’ve had two consecutive quarters where bonds have been wildly disappointing from a portfolio perspective. Why is this relevant? If I’m going to build a diversified model, which is ways that we have utilized for decades to try to control risk within strategies, and then suddenly… There’s always been pockets where correlations go to one across asset classes. It’s very rare that we see long-term sustained correlations of one between bonds and equities.

How Long Has It Been Since Bonds Have Had a Healthy Reset?

[00:32:57] Brad Kasper: But in the last six months, I’ve read more articles and seen more pieces around the death of 60/40. Everybody is saying that bonds are no longer relevant because they’re highly correlated to equities. Or at least that’s what it felt like. We went through six weeks earlier this year where S&P 500 was down less than the bonds. When I look under the hood of who’s my risk control within a portfolio, and they’re bleeding more than my equity counterparts, it feels like we’re in upside down world at that point. But here’s what I will state. How long has it been since bonds had a healthy reset?

[00:33:36] Dean Barber: 40 years.

[00:33:37] Brad Kasper: 40 years. This may be one of the healthiest resets for bonds.

[00:33:41] Dean Barber: But there has got to be more pain to come. If you go out and try to buy individual corporates today, you’re still playing a premium. They’re not even a par yet.

All Bonds Aren’t Created Equal

[00:33:54] Brad Kasper: Yeah. There needs to be a point where some of those come to a discount. And once they do, I think you find kind of this rush and flood back into the conviction of bonds. Hopefully, it’ll be at a point where the income is higher. We’ve been complaining about the Agg. Why invest in it? You can go get a higher paying dividend equity name in the value side versus my bond that’s paying sub 2%.

[00:34:18] Dean Barber: Right. But you need to be careful of the valuations on those equities too.

[00:34:21] Brad Kasper: But those valuations are wildly expensive. So, did we reprice the bond markets to a degree where they could be favorable? I’m not here to predict either way.

[00:34:32] Dean Barber: Let’s go to some different types of bonds, though, because bonds aren’t all created equal.

[00:34:39] Brad Kasper: That’s right.

Considering Bond Alternatives

[00:34:39] Dean Barber: You’ve got the STIP, which is the short-term inflation protected treasuries. It has a nice yield right now that’s a little over 5.5%. It’s also down 4% this year, but that’s better than the 10.5% that the bond Agg is down. With inflation continuing to run hot, you have a good chance that you could wind up with a slightly positive return in that type of an investment.

[00:35:08] Brad Kasper: When we look under the hood of the models that we have built out, there are a lot of fixed income positions. All of them have done better on a relative basis to the Barclays US bond Agg. But that doesn’t mean they’re not still negative. And I don’t say that in a bragging way. There is nothing that is a worse feeling than when your bonds are negative within your portfolio. That’s the component that people have come to learn and know to be the more conservative thing. So, I think Dean is hitting the right talking points. There are places within the fixed income space.

There Are Still Opportunities in the Bond Market

[00:35:45] Brad Kasper: When volatility is running high in bonds, shorten up your durations, improve your qualities, look outside of just kind of corporates. There are credit vehicles. I’m not suggesting high yields are a great buy at this point, but you have high yields, bank loans. There are other tools that you can utilize. We’ve taken advantage of a number of those to improve our relative outperformance. But by no stretch of the imagination is it completely offsetting what we’re seeing on the equity side of things. And that’s what we really need.

[00:36:16] Dean Barber: I think there’s also some good values out there right now on legacy mortgage-backed securities.

[00:36:22] Brad Kasper: MBS looks good. AMBS looks good.

[00:36:26] Dean Barber: The point is that there are opportunities in the bond market today.

[00:36:30] Brad Kasper: Finally.

[00:36:30] Dean Barber: Yeah. There are some opportunities. The thing is that most people’s money is in their 401(k) plans. They don’t have these options inside their 401(k) plans because the plan provider is saying those are too esoteric. Nobody is going to understand those. Nobody knows what they are.

Again, Inflation Is the Game Changer Right Now

[00:36:51] Brad Kasper: Or they’ll use a net long-term conversation that, “Oh, this’ll be just as good net long-term.”

[00:36:55] Dean Barber: And think about this. The 60/40, the Agg, has done well almost since the inception of 401(k) plans. 401(k) plans didn’t come into existence until the late 1970s. When you look at the last 40 years, bonds have been great. The bond Agg has been great. You’ve had maybe one or two slightly negative years.

In 2000, 2001 and 2002, we roll into that Dot-Com Bubble with nice 5.5, 6% interest rates. Then, the Dot-Com Bubble bursts and in comes the zero interest rate policy and recession. Interest rates start dropping. Bonds were making 15, 16% a year to offset the losses in your equities. But it’s not going to happen this time because of inflation.

The Risk-Off Trade Still Goes to Bonds

[00:37:49] Brad Kasper: That’s the $1 million question, though, right? If we get into any type of sustainable recessionary environment, where’s the risk-off trade going to go?

[00:37:58] Dean Barber: It’s going to go to bonds.

[00:37:59] Brad Kasper: It’s going to go to bonds. Do we find ourselves in a scenario where we suddenly see a 3% 10-year treasury go back down to 1.5, 2%, if we got into a recession? I’m not suggesting that’s the case. I’m just saying that if we got into a real risk-off event, the US Treasury is still the best haven for assets to flow to.

A History Lesson in Bonds

I don’t think that this round would be any different if real pressure was being realized. And not just domestically, but on the global stage as well. So, it’s hard. I think there’s a relevant place for bonds within portfolios. And the only thing that I can tell anybody is when I get a question like, “Should we be sitting in bonds or what do we do at these lows?” I go back and I look at as much data as possible. I can take the Agg all the way back into the early 1970s.

[00:38:47] Brad Kasper: You have almost 60 years of history. All I can tell you is the last time we saw a market draw down on bonds—any of them, intermediate GVIs, intermediate munis, intermediate corporates—you’d have to go back to 1978 to find a period that bonds drew down 12%. The only one that drew down greater was the municipals. But that was a massive supply issue and balance sheet issue that was going on state levels back in the late 1970s. And it was all because of inflation. Since then, we’ve had several drawdowns. Typically, those drawdowns cap around 5 to 10% when you get into real serious market environments.

[00:39:42] Brad Kasper: When somebody asks me if we are going down another 20% on the Agg, I’d say there’s probably a greater probability that we’ve priced in a lot of the drawdown than not. Again, that doesn’t mean that we couldn’t see a 15, 20% drawdown. If something happens and that 10-year treasury starts moving, we could see it. But the probability of that happening based off what we know of 60 years of history is minimal at this point. It’s lower than the odds of bonds settling in and doing better going forward.

We Were in a Zero Interest Rate Environment (or Close to It) for a Long Time

[00:40:08] Dean Barber: I think the biggest difference is that we’ve never been at a time in history where we sat at virtually a zero interest rate policy for 14 years. We’re coming off low to mid 1% on the 10-year treasury. For us to say everything is going to be fine, we need to expect that this 10-year treasury is going to start dropping in yield. But how can we have a 10-year treasury dropping in yield when the Fed fund wants to be at 3 to 3.5%?

[00:40:40] Brad Kasper: Well, it’s going to take a lot of stones for the Fed to raise rates if there is a significant enough event that is causing people to kind of go to the risk-off posturing.

Getting to a Normal Interest Rate Environment Likely Means More Pain in Bonds

[00:40:49] Dean Barber: Right. But eventually, though, we need to get back to a more normal monetary policy, normal interest rate environment.

[00:40:55] Brad Kasper: I’ve preached that since 2009. Even that great experiment still hasn’t unwound.

[00:41:01] Dean Barber: But the reason I say that is because I don’t think the pain’s done. I think that if we’re going to get to a more normal interest rate environment, which is what we need to do, there’s going to be more pain in the bond aggregate.

[00:41:16] Brad Kasper: Very well could be. But what I try to think about is that there is a premium that’s paid to carry risk assets, right? And like it or not, bonds are risk asset, equities are a risk asset. The premium is the drawdown, the pain that you experience during these types of market cycles. So, our job is not necessarily to project where it’s going. It’s to sit here and say, “Do we still have good players that are going to help us wade through this next round of whatever it looks like?” And what keeps popping up on our screens and talking points is more along the lines of there could be more to go, but there’s a higher probability that a lot of the down has probably been priced in. That said, remember that I used the S&P 500 as my example earlier. It was down 35% in 2020.

How Low Will We Go?

[00:42:07] Brad Kasper: We haven’t even touched the lows of what we did in 2020. In 2008-2009, it drew down 47% in a two-year timeframe. We’re not even close to that. The same exercise you should do with your valuations on stock names needs to be done on your bond names as well. Can you still hold this? If this thing goes down 40% on the S&P 500, can you stomach your equities? If the Agg goes down to 20%, can you stomach that within your bonds?

We need to be a little bit more dynamic if you can’t hold that. We have tried to do that with some of the models. And as you know, we’re not purely in a Barclays US bond Agg type of position and equities. We have a little bit of everything. But we’ve been hit by some of the growth and tech movement as well.

Asset Allocation and Probability of Success

[00:42:56] Dean Barber: I think we can wrap up here by talking about what allocation a person should have today. I just want to give a recent example of a meeting that I had with one of our CERTIFIED FINANCIAL PLANNER™ Professionals and a couple of our clients. With the financial planning tool that we use, we can look at the total value of your assets, total income need, what Social Security is going to be, your taxes. We look at everything and build the plan out. And then we can go from 100% cash to 10% stocks, 90% bonds, all the way up to where you get to 100% stocks, right?

[00:43:40] Brad Kasper: Sure.

[00:43:40] Dean Barber: In this couple’s particular plan, their probability of achieving their overall retirement objectives was a 95% probability of success with a 20/80 portfolio. That’s 20% equities, 80% fixed income. By the time they got to 70% equity and 30% fixed income, the probability of success had dropped down to 93%. It continued to drop with the more equity exposure we got. So, if you don’t know what actual allocation gives you the highest probability of achieving your financial objectives, then you sit back and listen to a conversation like Brad and I just had, and you’re like, “Well, I don’t know what to do now.” You can know exactly what to do but need to have the proper financial plan and be working with a competent CFP® Professional to do it.

It All Starts with a Financial Plan

[00:44:33] Brad Kasper: I’m glad you brought it all full circle here. The purpose of any model portfolio that you build or strategy that you’re looking at accommodating the goals of what you’re trying to achieve within a financial plan. Without it, I think you’re just aimlessly investing.

[00:44:48] Dean Barber: Yeah. We tell people all the time to not call us or come see us if all they want to do is talk about asset allocation. I’m not going to talk about asset allocation until I’ve done a full-blown financial plan and know what your money needs to do. Once I know what your money needs to do, then we can start having a discussion around asset allocation and what’s proper and what’s best. And we can show you in black and white what the real numbers are and what do you need to be doing.

Low Inflationary Targets in a Financial Plan Can Lead to A Lot of Problems

[00:45:15] Brad Kasper: Yeah. It brings relevancy to the conversation that we had earlier. Who cares what the PE is on Tesla if that has no bearing on your ability to find success in your financial plan? You don’t need to have the conversation. But I think bonds are a relevant conversation because, as Dean said, it’s probably going to be a part of long-term asset allocation planning anywhere you’re going. And what I think is wildly entertaining is that a lot of people that are running projections and are looking at inflation that are using low inflationary targets.

[00:44:55] Dean Barber: They have in the past, yeah.

[00:45:56] Brad Kasper: That’s wildly problematic, right?

[00:45:57] Dean Barber: It’s very problematic. I’ve seen multiple times where people will come into our office, and they’ve already had a financial plan done by another advisor. We log into their online access and the financial planner was assuming a 2% inflation rate. I’m like, that’s not going to work. Let’s put 4% in there and see what happens. Then, the whole plan crashes.

[00:46:19] Brad Kasper: Sure. Yeah. And think about that, we’re at 9.1%. And I’m not saying we need to project that out because there are greater odds that that’s going to cool.

Accomplishing Your Objectives

[00:46:28] Dean Barber: Exactly right. And to do that, you go back and use the financial planning tool, do the historical tests, and things like that. There are ways to measure that and see exactly what that was. But it all does come back to what’s important to the person. How are they going to accomplish their objectives? And then you can get into this discussion. Leave this complicated stuff that Dean and I are talking about today to the professionals.

[00:46:49] Brad Kasper: Yeah. It’s just going to get more and more complicated over the next couple of quarters as we try to digest all this. I was talking to an old college professor that’s become a friend of mine over the years and he was showing me his financial plan. I asked what benchmark he was using. He goes, “It’s just CPI. I use inflation as my benchmark. I’ve been outperforming it for years until the last year because inflation has been darn near sub 2% for a decade. Now, it’s up at 9%.” So, I asked him why he does that. Well, he said he just needs his money to be able to outpace inflation over time. I thought that was a wildly simplistic and powerful way to think about it.

Getting Your Real Return

[00:47:43] Dean Barber: Yeah. We do the same thing with our financial planning tool. We look for a real return. So, you have the return on the investment minus inflation. That’s your real return. Then, what are your withdrawal requirements? And can we maintain a positive number after we subtract the inflation and the withdrawal amount from your portfolio value? Right now, it’s super difficult with where we’re at today.

[00:48:11] Brad Kasper: Yeah. But think about 2008. I remember a time in late 2008, where suddenly your three-year and five-year numbers on a lot of these investments were just annihilated after that movement. I was saying to myself, “I can’t even imagine a cycle that gets us back to 8, 9% averages on some of these five and 10 years. The positive thing is that it did happen. It’s just a matter of time.

We need to make sure that we are calm, cool, and collected through these types of market movements. We need to understand the risks that are associated with the underlying posturing that you’re using from a model perspective. And most importantly, we need to make sure it aligns with what your financial plan is asking you to achieve. If you line up all three of those things, I’d say your probabilities improve dramatically. And as you can tell, I do a lot with probabilities and outcomes. I think that’s still the best way to handle things.

We’re Always Looking Forward

[00:49:08] Dean Barber: I agree. Brad, thank you so much for taking the time to join me on The Guided Retirement Show. I hope everybody enjoyed our discussion about the multiple headwinds that the Fed and the markets are facing. As we continue to monitor the multiple headwinds that the Fed and markets are facing, we hope you understand how critical it is to have a financial plan in place. To build off our discussion, I’m giving you the opportunity to use the same financial planning tool that our CERTIFIED FINANCIAL PLANNER™ Professionals use at no cost or obligation. You can see some of the things we talked about from a more personal level by clicking the “Start Planning” button below.

START PLANNING

You are also more than welcome to schedule a 20-minute “ask anything” session or complimentary consultation with one of our CERTIFIED FINANCIAL PLANNER™ Professionals. We can discuss what your asset allocation should be, not only now, but at any point in your life. You really need to understand that. Thanks again for joining us here on The Guided Retirement Show.

[00:49:53] Dean Barber: As always, thank you for joining us on the podcast. Don’t forget to subscribe so you never miss an episode. Check us out on YouTube for full episodes on video and leave us a review if you’re on Apple podcasts.

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