Earnings Season is Set to Begin + Financial Market Update + 4.13.21

Earnings Season is Set to Begin + Financial Market Update + 4.13.21

FINANCIAL MARKET UPDATE 4.13.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

EARNINGS SEASON IS SET TO BEGIN

Earnings season will kick off this week, with a handful of the big banks reporting results for the 1st quarter. The narrative in the market in recent months has been that progress in the nation’s vaccination program, coupled with extremely accommodative monetary and fiscal policy, should spark an explosion in business activity over the course of the year. Clearly, these optimistic expectations have found their way into asset prices, as the stock market appears to be somewhere between fully and richly valued. For the market to continue to justify current levels (or higher), reported results need to start reflecting the optimistic outlook.

To understand how business results impact stock prices, we can decompose stock returns into a variety of sources. A simplified model looks like this:

Return = dividends + earnings growth + change in valuation

Based on this equation, the return on a stock (or the stock market) is based on the dividends received, growth in earnings, and changes to how much investors are willing to pay for those earnings. Over the 12 month period ending on 3/31/21, the S&P 500 gained about 56%. During this time, dividends paid were slightly below 2%, while the growth in earnings was about 4% (according to FactSet). This suggests the bulk of the gain in the stock market has been due to a change in valuation. The chart below from JP Morgan supports this view.

The grey line in the above chart represents the forward P/E ratio, which is the current market price over the earnings that analysts are forecasting over the next 12 months. As you can see, the grey line dips dramatically in early 2020, only to shoot higher as the market recovered and subsequently hit new all-time highs. This demonstrates a substantial increase in valuation, generally referred to as ‘multiples expansion’ (the multiple of price over earnings (P/E) has expanded). A logical explanation for why the forward P/E increased so much is that interest rates are near historic lows, making the stock market look attractively priced in comparison. Investors, therefore, should be willing to pay a higher price for stocks. At some point, the Federal Reserve will raise interest rates again, however, and stocks will begin to look less attractive in comparison.

Another explanation for the lofty valuations is that investors are expecting earnings to increase dramatically in the not-so-distant future. According to data provided by FactSet, analysts are expecting rapid growth in YoY earnings over the next several quarters, which should be at least partially reflected in the forward P/E ratio. If investors are pricing in an even higher level of growth, it would make sense to see the forward P/E ratio rising. This can give rise to some confusing market reactions as companies publish their results. If the market is pricing in more growth than analysts were forecasting, you have a situation where companies can beat earnings estimates but subsequently sell-off in the market.

Ultimately, valuations tend to revert towards their long-term averages over time. With most measures of value currently well above average, there are two general ways this can play out. Either the large-cap stocks of the S&P 500 will see their prices correct and decline to a more sustainable level, or business results will live up to their lofty expectations. Investors will be watching earnings reports and gauging company outlooks closely for clues as to which direction we are heading.

WEEK IN REVIEW

  • The fight against COVID-19 has hit a few stumbling blocks in recent days. Setbacks include rising case counts, despite the accelerating pace of vaccinations and an announcement from the FDA that it is advising the J&J vaccine usage be paused out of an abundance of caution. The halt stems from six reported cases of blood clotting out of millions of people that have taken the vaccine.
  • The Labor Department published updated Consumer Price Index (CPI) data this morning. The report showed that prices increased by 2.6% YoY, the most rapid pace of price increases since August of 2018. The bulk of the price increases came from gasoline, which increased by 9.1% in March. The less volatile ‘Core CPI,’ which strips out food and energy prices, increased by 1.6% YoY. Investors will be watching the incoming inflation data very closely, given its implication on monetary policy. There seems to be a consensus that inflation will rise through the Spring, given the ‘base effect’ caused by the week reading current prices are being compared with. The main question is: whether higher inflation is transitory or here to stay.
  • Additional developments to watch for this week include a variety of Fed speakers on Wednesday, industrial production, capacity utilization and jobless claims on Thursday, and consumer sentiment and housing data on Friday.

HOT READS

Markets

  • Consumer Prices Rise More than Expected, Pushed By 9.1% Jump in Gasoline (CNBC)
  • Banks, After Bracing for Disaster, Are Now Ready for a Boom (WSJ)
  • FDA Halts Use of J&J Covid Vaccine Due to Rare Blood-Clotting Issue (CNBC)

Investing

Other

  • What Happens Now to the NFL Prospects Who Opted Out of Their Final College Season? (SI)
  • For the First Time, a Spacecraft Caught an Active Satellite to Extend its Life (CNBC)
  • Companies Can’t Stop Overworking (NYT)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

Earnings Season is Set to Begin + Financial Market Update + 4.13.21

Should You be Concerned About the recent Rise in Bond Yields? + Financial market Update + 3.30.21

FINANCIAL MARKET UPDATE 3.30.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

SHOULD you BE CONCERNED ABOUT THE RECENT RISE IN BOND YIELDS?

Since the beginning of the year, we have seen a rapid increase in the general level of interest rates. The widely cited 10 Year Treasury yield has nearly doubled in 2021, rising by 0.80% to 1.73% as of yesterday’s close. After delivering high single-digit returns in both 2019 and 2020, the US bond market has been under pressure as a result of the yield increase. Down 3.43% year-to-date, bonds(1) are on pace for their worst calendar year return in over forty years.

Red ink does not show up in a portfolio of high-quality investment-grade bonds very often, but when it does, investors tend to question why they own bonds in the first place. Here are a few reminders for how bonds work, how you can mitigate interest rate risk, and how investors should think about their bond allocations moving forward.

Why Rate Moves Impact Bond Prices

If you find yourself reading an article about bonds in the Wall Street Journal (or similar pub), you are virtually guaranteed to see a statement similar to: bond prices move inversely with rates. This is a concise way to explain that when yields rise, you should expect bond prices to fall and vice versa. To understand why this is the case, the following is a simplified example.

A company needs to borrow money, so it issues a 10-year bond that pays interest of 3%. The 3% interest payment, referred to as the ‘coupon,’ is set by prevailing interest rates at the time of issuance and is often fixed over the life of the bond. Let’s assume that a few years after the company sold its bonds to investors, prevailing interest rates increased from 3.0% to 4.0%. The investors that purchased the bond now face a problem. Their investment is only paying a 3.0% coupon, while other new bonds are paying 4.0%. The investors are missing out on higher interest payments, but they can’t sell their bond at full face value because nobody wants their crappy 3.0% bond. To entice somebody to buy the bond, the original investors must lower the price. In simple terms, the price will fall to the point that the fixed coupon payment divided by the bond price will equal the prevailing market interest rate. The opposite holds true if the prevailing market rate were to fall below the fixed coupon. In that scenario, the investors that held the 3.0% coupon bond would be earning more interest than newly issued bonds and could sell it to another investor at a premium.

Mitigating Interest Rate Sensitivity

The sensitivity of bonds to interest rate movements can be illustrated by a measure known as duration. As a general rule of thumb, a 1.0% move in interest rates will move the value of the bond by an amount equal to its duration. Generally, a bond with a duration of three will see its value rise/fall 3.0% for a 1.0% decrease/increase in interest rates. This concept can be applied to individual bonds, bond funds, and portfolios comprised of individual bonds and bond funds. Investors concerned about rising rates can mitigate that risk by lowering the duration of their portfolio. For reference, the Bloomberg Barclays Aggregate Bond Index has a duration of about six.

Another way to mitigate a portfolio’s interest rate sensitivity is to diversify the types of bonds held. Allocating to international bonds can be an effective way to do this, as interest rates in other countries do not move in lock-step with US rates. Treasury Inflation-Protected Securities (TIPS) offer another avenue for diversification, as their prices respond to changes in real yields, as opposed to nominal yields, and those yield movements are not perfectly correlated.

Other options for mitigating interest rate risk generally focus on ‘bond substitutes.’ This category includes utility stocks, REITs, preferred stocks, business development companies (BDCS), master limited partnerships (MLPS), and certain options strategies. Each of these alternatives suffers from some combination of:

  • Substantially higher volatility compared to high-quality bonds
  • Similar interest rate sensitivity to bonds
  • Higher correlation with stocks

There is no Substitution

For most investors, the bond allocation’s primary role is to provide portfolio stability. High-quality bonds with a short to intermediate duration carry substantially less volatility than stocks. For context, the US bond market’s(1) worst calendar year return over the past forty years was -2.92% (1994). Granted, interest rates have steadily declined in recent decades, so it would not be unreasonable to believe the road ahead could be bumpier. Still, the stock market frequently experiences volatility on a scale several magnitudes higher than bonds and will likely continue to do so in the future even if rates were to migrate higher.

When considering investment risk, it is critical to evaluate the portfolio as a whole. Bonds have a low and sometimes negative correlation with stocks. This means the price of bonds will often zig when an investor’s stock portfolio is zagging. The result can be a dramatic reduction in the fluctuation of a portfolio’s value, and the diversification benefit delivered by bonds generally increases with a higher duration. Investors seeking to eliminate interest rate risk in their bond allocation may increase their overall portfolio risk. As the portfolio’s stabilizers (bonds) are removed, the dominant driver of overall portfolio risk (stocks) goes unchecked.

While it may be uncomfortable, there are a couple of reasons investors should accept interest rate risk, even if that means a portion of their portfolio will continue to be under pressure. First, at least part of the rise in rates may be attributed to the expectation for accelerating economic growth. This is generally a positive tailwind for stocks, which can offset the weakness in bonds. Second, bonds are sometimes referred to as the self-healing asset class. When rates increase, their prices fall. That is obviously a negative, but there is also an important positive. Moving forward, interest payments received can be reinvested at higher prevailing interest rates. Over time, this can lead to a portfolio return that is actually higher than it otherwise would have been if interest rates had not moved.

1. Represented by the Bloomberg Barclays Aggregate Bond Index

WEEK IN REVIEW

  • Interest rates continue to grind higher. The ten-year Treasury is currently trading at 1.73%, around the highest level in 14 months. Mortgage rates have followed Treasuries higher, with the national average 30 year fixed mortgage rate increasing to 3.17% this week, according to Freddie Mac.
  • It’s a big week for economic data, as the Bureau of Labor Statistics publishes the payroll report on the first Friday of each month. According to MarketWatch, economists are expecting a massive increase in jobs from 379,000 in February to 675,000 in March. Other data to watch for this week include an update on the manufacturing sector for March and jobless claims on Thursday.
  • Home price appreciation accelerated to the fastest pace in 15 years during January, as the supply of homes for sale continued to decline. The S&P 500 CoreLogic Case-Shiller National Home price index showed the average home price in the 20 largest US metro areas increased by 11.1%.

HOT READS

Markets

  • SPACs Are the Stock Market’s Hottest Trend. Here’s How They Work (WSJ)
  • Powell Praises Economic Recovery and Sees Fed Pulling Back Help After ‘Substantial’ Progress (CNBC)
  • IMF to Raise Global Growth Forecasts on US Stimulus and Covid Vaccination Progress (CNBC)

Investing

Other

  • This Workout Adds Speed to Your Golf Swing, and Improves Balance and Rotation (WSJ)
  • The Paint Job on Your Car is Crucial to Resale Value (NYT)
  • Get Moving With Our Favorite Fitness Apps and Services (Wired)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

Earnings Season is Set to Begin + Financial Market Update + 4.13.21

Lessons from the COVID Crash + Financial Market Update + 3.23.21

FINANCIAL MARKET UPDATE 3.23.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

LESSONS FROM THE COVID CRASH

On this day one year ago, the stock market reached the lowest point during the pandemic-related crash. From the all-time high set the month prior, the S&P 500 fell roughly 34% in 23 trading days as investors tried to assess Covid-19’s impact on the economy. By some measures, the selloff was the most rapid on record, with March experiencing a few of the largest single-day declines of the last 90 years (trailing only the Black Monday crash in October 1987). At the time, few were calling for the selling to subside. Weeks into the market’s recovery, many market pundits were still predicting that we had not yet seen the bottom. Fast forward to today, and the S&P 500 is up about 76% from the low, representing about six years’ worth of market gains crammed into one. Let’s take a moment to reflect on some of the lessons learned from this dramatic market episode.

Prices are Forward-Looking

Asset prices are driven by expectations for the future. This critical concept generated considerable confusion during the selloff and subsequent recovery, leaving many investors feeling as though the market was disconnected from reality. As an example, the S&P 500 peaked on February 19th and quickly began to decline thereafter. The losses accelerated before the lockdowns began and well before their impact showed up in the economic data. With uncertainty building, investors incorporated the potential for extreme downside scenarios into asset prices. The jobless claims report published on March 26th, which illustrated a record number of employee layoffs, was the first piece of data to reflect the economy’s slowdown. By that time, however, the market was already a few days into the recovery! A significant degree of monetary stimulus enacted by the Federal Reserve and expectations for fiscal stimulus from Congress provided the market confidence that the economy could weather the public health crisis. This led to recovering asset prices well before any improvement in the economy or the fight against Covid-19.

 

Diversification Still Works

With interest rates anchored at persistently low levels over the last 10 years, many have questioned how effectively bonds would be able to diversify a portfolio. When the market selloff began, the 10 year Treasury bond was yielding about 1.56%, which is actually lower than what it yields today. While stocks declined about 34%, high-quality bonds, proxied by the iShares 3-7 Year Treasury Bond ETF, gained about 4.2%. During the market crash, high quality-bonds offered much-needed stability to investor portfolios. They provided the opportunity to rebalance by selling assets that had held up well and buying assets that had become discounted. For investors that cannot stomach the gyrations of an all-equity portfolio, incorporating bonds continues to be a great way to reduce volatility.

 

You Can’t Time the Market

Witnessing the market decline as much as it did last year can be a harrowing experience. For many, there was a strong temptation to sell stocks to avoid further losses. There are a variety of problems with doing this. For starters, if an investor is comfortable holding stocks prior to a selloff, a subsequent decline should make them more attractive, not less. As the price of a well-diversified portfolio declines, its prospective return increases. Additionally, there is never an “all clear” sign that signals it is time to get back in. The timing of a market rebound can only be known in hindsight. By definition, the recovery does not begin until prices hit their bottom, which generally occurs when the outlook is the least favorable. Investors that get out of the market to wait for the dust to settle are not only giving up the gains associated with the initial recovery, but they are effectively waiting for prices to rise, which lowers future expected returns. Making matters worse, many investors that sell near the bottom endure the similarly painful experience of watching the market recover without them in it.

While it is more comfortable to own stocks when they are rising, it is important to remember that the discomfort associated with market volatility is precisely the reason stocks typically generate higher returns than less volatile alternatives like cash and bonds. It is one thing to want the reward for investing in a diversified equity portfolio. It is another to stick with the allocation through thick and thin. Only investors that stay disciplined will reap that benefit. Those that cannot are often penalized by losses that become locked in through selling.

Perhaps the most important lesson from the selloff last year is that it is critical to make a plan when things are calm, for the reality that they will not always be. This wasn’t the first time the markets have crashed, and it certainly won’t be the last. The key to investment success is creating a plan and then sticking to it.

WEEK IN REVIEW

  • Last week the Federal Reserve announced its decision to keep its benchmark interest rate unchanged at 0.00 – 0.25% as expected. Additionally, there were no announced changes to the current bond buying program (QE).
  • Once a quarter, the Fed publishes its Summary of Economic Projections (commonly referred to as the dot plot). The most recent dot plot published last Wednesday reflected a significant improvement in the Fed’s outlook on the economy. GDP estimates for 2021 were increased from 4.2% to 6.5%, unemployment expectations declined from 5.0% to 4.5%, and inflation estimates for the year increased to 2.4% from 1.8%. Finally, four Fed officials expected at least one 0.25% rate hike by the end of 2022. When the previous dot plot was published in December, only one official believed there would be an increase in 2022.
  • Notable economic data to be published this week includes durable goods orders and a prelim reading on services and manufacturing PMIs on Wednesday, jobless claims and a revised Q4 GDP estimate on Thursday, and consumer sentiment and inflation on Friday.

HOT READS

Markets

  • SPACS Break 2020 Record in Just 3 Months (CNBC)
  • Here’s Where the Federal Reserve Sees Interest Rates, the Economy and Inflation Going (CNBC)
  • Existing Home Sales Fell Sharply in February, as Supply Dropped by the Largest Amount on Record (CNBC)

Investing

Other

  • Are Electric Cars really Better for the Environment (WSJ)
  • Why US Hospitals Are Closing (CNBC) Video
  • Where Are Those Shoes You Ordered? Check the Ocean Floor (Wired)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

Earnings Season is Set to Begin + Financial Market Update + 4.13.21

Rising Rates, Inflation & the Fed + Financial Market Update + 3.16.21

FINANCIAL MARKET UPDATE 3.16.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

RISING RATES, INFLATION & THE FED

All eyes will be on the Federal Reserve this week when they make their monetary policy announcement on Wednesday. The market typically follows these announcements closely, but this Fed meeting will likely garner even more attention than normal. Roughly a year after the pandemic-related lockdowns began, economic activity appears poised to accelerate, and the market will be looking for clues on how and when the Fed will unwind its emergency interventions. While the outcome of any single Federal Reserve meeting is generally not impactful for long-term investors, these events have the ability to generate some near-term volatility. Here is a high-level overview of some of the important storylines related to the meeting.

Interest Rates Have Been Rising

The Fed has held rates near zero since March of last year, yet longer-term interest rates have increased dramatically over the past six months. How is this possible? The Fed sets interest rates using the ‘Federal Funds Rate,’ which is the rate banks can borrow and lend their excess reserves to each other overnight. Overnight is obviously an extremely short period, so the Fed’s primary policy tool is based on managing short-term rates. The recent increase in rates has primarily occurred in longer-term instruments. This would include the 10-Year Treasury, which is the primary benchmark for a substantial amount of longer-term lending, including residential mortgages. Visit any financial news website, and the interest rate component of the ticker tape at the top of the page will be the 10-Year Treasury.

While long-term rates generally respond to movements in short-term rates, they do not move in lockstep. The term premium, defined as the extra compensation an investor or lender requires for locking up their money for an extended period, changes over time based on growth and inflation expectations. An increase in these expectations can increase the term premium and, therefore, longer-term rates.

Movements in interest rates can extend beyond the bond market and into stocks as well. The manner in which stocks respond is not always straightforward, however. On the one hand, rising rates are a headwind because they represent tighter financial conditions and higher borrowing costs. Additionally, the value of a stock is estimated as the sum of all future cash flows, such as dividends, discounted back to present. Mathematically, the value of those future cash flows decreases as the discount rate increases. For high-growth companies whose actual cash flows are far into the future, the impact of a rising discount rate is felt more severely. This notion has been used to explain the recent underperformance of the high-growth technology sector. On the other hand, rates are still near historically low levels, and if they are rising because the economy is picking up speed, you could argue that stocks should do well in such an environment.

Accelerating Economic Growth and Inflation

As vaccine rollouts progress, social distancing restrictions ease, and the new fiscal stimulus package is dispensed, economic growth is expected to accelerate. Inflation is also expected to accelerate, with both realized and expected inflation at or moving towards the highest levels in years. Inflation is typically measured as the year-over-year price change for a basket of goods. Over the next couple of months, current prices will be compared to the depressed price levels prevalent during the peak of the pandemic-related lockdowns. Sometimes referred to as the ‘base effect,’ these comparisons will provide the appearance of accelerating price increases. The big question is whether these inflation pressures are transitory or here to stay. There are convincing arguments on both sides of the debate.

Those that believe a sustained increase in inflation is approaching typically point to the growth in the money supply. The graph below illustrates the “M2” calculation for the money supply, which includes cash, checking deposits, savings deposits, money market securities, mutual funds, and other time deposits. Essentially cash or other holdings that can quickly be converted to cash. The year-over-year increase in M2 is 25%, which dwarfs the growth in any other period since the 1960s. The growth in the money supply heavily influences inflation in a relationship that can be summarized as “too much money chasing too few goods.”

The argument against sustained inflation generally centers on the “slack” currently evident in the economy. This refers to the high level of unemployment (people who want to work but can’t find a job) and wide output gap (what the economy is producing versus what it is capable of producing). Inflation is not typically an issue in this environment because there are untapped resources available to satisfy increasing demand.

The Fed Announcement

We are approaching a crossroads. The Fed deployed a heavy dose of monetary stimulus to combat the lockdown-induced recession. With the economy well on the way to recovery, the Fed will need to withdrawal the stimulus at some point, but doing so requires a very delicate handoff. If the Fed is too slow, it risks overheating the market, economy and inflation. If the Fed is too aggressive, it could hamper the economic recovery and send shockwaves through the markets as assets reprice to reflect the new path of policy.

The Fed has previously articulated its belief that inflation pressures are transitory. It will maintain some of its non-traditional measures of accommodative policy (bond purchases) and maintain interest rates near zero for the foreseeable future. If the message delivered upon conclusion of the meeting is materially different from what the market is expecting, we could see some volatility.

WEEK IN REVIEW

  • Data published by the commerce department last week showed that retail sales fell more than expected during February (-3.0% vs. -0.5%). The decline was attributable to severe winter weather that gripped much of the country and a slowdown from January’s figure that was augmented by $600 stimulus checks. The January retail sales figure was increased from 5.3% to 7.6%, so the growth in consumption activity remains strong so far in 2021 and will likely get a boost from the recently passed stimulus package.
  • As mentioned in the Story of the Week section, the Fed announcement at 1 PM CT on Wednesday will be the highlight of the week. Investors will heavily scrutinize the official Fed Statement, post-meeting press conference, and updated summary of economic projections (dot plot).
  • Other economic data to watch for during the week includes housing data on Wednesday, and jobless claims and the Index of Leading Economic Indicators on Thursday.

HOT READS

Markets

  • The Pandemic Ignited a Housing Boom – But It’s Different From the Last One (WSJ)
  • Harsh Weather Temporarily Weighs on U.S. Retail Sales in February (CNBC)

Investing

  • Investing: The Greatest Show on Earth (Morgan Housel)
  • Lessons from Charlie Munger at the Daily Journal Meeting (Novel Investor)
  • Four Things Everyone Needs to Know about the Markets (Ben Carlson)

Other

  • The NFL Coach, the Nobel Prize Winner and One Crazy Idea to Fix Overtime (WSJ)
  • The Month Coronavirus Unraveled American Business (WSJ Video Documentary)
  • The U.S. Solar Industry Posted Record Growth in 2020 Despite Covid-19, New Report Finds (CNBC)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

Do you want to receive financial market updates in your inbox? Sign up here! 

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

P: 402.827.2300 | F: 402.827.2319 | E: contact@lutzfinancial.com | 13616 California Street | Suite 200 | Omaha, NE 68154

All content © 2017 Lutz Financial  | Important Disclosure Information |  Privacy Policy

FORM CRS RELATIONSHIP SUMMARY

3.3.21 | Financial Market Update | Recording

3.3.21 | Financial Market Update | Recording

 

LUTZ BUSINESS INSIGHTS

 

Financial Market Update

3.3.2021 | FINANCIAL MARKET UPDATE | RECORDING

Investment topics are always top of mind with our clients as the markets are constantly changing and evolving. The constant noise around financial markets can be distracting and confusing. It’s important to cut through that noise and be pragmatic long-term. In this presentation, Chief Investment Officer, Josh Jenkins, and Financial Adviser and Principal, Justin Vossen, from Lutz Financial analyze the current state of the markets and examine thoughtful approaches to investing.

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Earnings Season is Set to Begin + Financial Market Update + 4.13.21

The Case for International Stocks + Financial Market Update + 3.2.21

FINANCIAL MARKET UPDATE 3.2.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE CASE FOR INTERNATIONAL STOCKS

Decisions made by investors are often impacted by an array of behavioral biases. A very prevalent example of this would be the Home Bias, which can be described as the tendency to stick with what is familiar. This bias often manifests itself in investor portfolios as a dramatic emphasis on stocks from the country in which an investor lives. The net effect of this type of home bias is an allocation that is not sufficiently diversified and therefore carries additional and unnecessary risks.

Diversification is often referred to as the only “free lunch” in investing because it can improve risk adjusted-returns at little to no cost. Unfortunately, many investors don’t take full advantage of this benefit, particularly as it relates to investing in non-US companies. I pulled the chart below from a Vanguard study(1) from a few years ago. As you can see, US-based investors have typically allocated about 79% of their portfolios to US stocks, despite the US market only comprising about 51% of the global stock market at the time(2). The home bias is not just a US phenomenon. It is even more dramatic in other countries whose markets comprise much smaller portions of the global market.

Equity Home Bias by Country

Notes: Data as of December 31, 2014 (the latest available from the International Monetary Fund, or IMF) in U.S. dollars. Domestic investment is calculated by subtracting total foreign investment (as reported by the IMF) in a given country from its market capitalization in the MSCI All Country World Index. Given that the IMF data is voluntary, there may be some discrepancies between the market values in the survey and the MSCI ACWI. Sources: Vanguard, based on data from the IMF’s Coordinated Portfolio Investment Survey (2014), Barclays, Thomson Reuters Datastream, and FactSet.

In recent years, the US market has consistently outperformed international markets as a whole. Having a large home bias, therefore, has likely contributed to higher returns. Moving forward, we think there is a compelling case for investing outside of the US.

1. Higher Expected Returns

International stocks have not participated in the post-Financial Crisis (2008) bull market to the same degree that US stocks have. Investors concerned about the nosebleed valuations of domestic companies, particularly the large tech names that have driven the market higher in recent years, can find relatively attractive bargains abroad. As the chart below illustrates, the valuation of the international market relative to the domestic market is currently at an extreme level. This suggests international stocks are poised to outperform as that relationship normalizes. Lastly, the lower valuation generates a higher dividend yield for international companies. As of the end of January, the dividend yield on the S&P 500 was 1.6%, compared to the broad international market’s 2.7%(3).

Data from Morningstar Direct, as of 1/31/21. The relative measure compares an equally weighted composite of P/E, P/B, P/S, and P/CF for the MSCI EAFE Index relative to the Russell 3000, which is used as a proxy for the US market. Gaps in the green valuation line reflect missing source data.

2. Lower Portfolio Volatility

International stocks are not perfectly correlated with their US counterparts. As a result, combining them in a portfolio typically reduces volatility. The chart below, from Vanguard, illustrates this benefit. Based on their study, the maximum volatility reduction occurs when 20-50% of the equity portfolio is diversified into non-US stocks.

Volatility Reduction from incorporating International Equities

Notes: Non-U.S. equities represented by MSCI World Index ex USA and U.S. stocks are represented by the MSCI USA Index from March 31, 1970, through March 31, 2020. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Sources: Derived from data provided by Vanguard and MSCI as of March 31, 2020.

It is very common for investors to exhibit some degree of home bias in their portfolios. While allocating heavily to US stocks has not hurt returns in recent years, our base expectation is that international stocks are priced to have higher returns moving forward. Additionally, international stocks provide the added benefits of improved diversification and lower portfolio volatility. We think this provides a compelling case for investing in international stocks moving forward.

1. Scott, Brian J., James Balsamo, Kelly N. McShane, and Christos Tasopoulos, 2017. The Global Case for Strategic Asset Allocation and an Examination of Home Bias. Valley Forge, Pa.: The Vanguard Group.

2. The US market is currently closer to 58% of the global market based on the MSCI All Country World Index

3. The international market dividend yield is based on the MSCI All Country World Ex-US Index

WEEK IN REVIEW

  • The Institute for Supply Management (ISM) published their Manufacturing Index, which showed manufacturing activity beat economist estimates last month, hitting the highest level since early 2018. The manufacturing data, combined with other strong economic data recently is pushing estimates for Q1 GDP higher. The Atlanta Fed’s GDPNow model, updated yesterday, now shows an estimated 10% annualized GDP growth rate for the quarter.
  • 96% of S&P 500 companies have reported earnings for the 4th quarter. According to Factset, 79% beat analyst estimates for earnings, while 76% beat revenue estimates. The earnings growth rate for companies that have reported Q4 earnings, blended with the estimates for companies that have not yet reported, has increased to 3.9%. The estimated YoY growth rate as of year-end was -9.4%. Earnings growth will need to continue to outpace near-term expectations for stocks to justify their current prices. Analysts typically revise estimates lower during the course of a quarter. After the first two months of Q1 2021, analysts have actually increased their estimates by 5.0%. That is a positive sign for the stock market.
  • There is a heavy slate of economic data still to come this week. On Wednesday, look for an update on services activity. On Thursday, we will get jobless claims and factory orders. Headlining the week of data will be the jobs report on Friday. Additionally, there will also be a handful of Federal Reserve speeches throughout the week. The market is anticipating some potential policy adjustments from the Fed at their March meeting. These adjustments include a change to the maturity profile within the Fed’s bond buying program (previously dubbed Operation Twist), where the Fed would sell shorter data bonds in favor of longer data bonds. Additionally, the market is expecting a potential increase to the interest on excess reserves (IOER) rate and reverse repo rate. These adjustments would not represent a change to their monetary policy stance; rather, they would focus on maintaining smooth market function.

HOT READS

Markets

  • Is Inflation a Risk? Not Now, But Some See Danger Ahead (WSJ)
  • Fed Policy Changes Could Be Coming In Response to Bond Market Turmoil, Economists Say (CNBC)
  • U.S. Factory Activity Scales Three-Year High, Price Pressures Building (Reuters)

Investing

  • The Stock Market is Smarter than All of Us (Ben Carlson)
  • Investors Piled Into This Magical Money Machine. Now They’re Stuck (Jason Zweig)
  • Berkshire Hathaway Letter to Shareholders (Warren Buffett)

Other

  • How Covid-19 Caused a Global Shortage of Semiconductors and Computer Chips (CNBC)
  • Aging Gracefully in the NBA Has Never Been Harder (Sports Illustrated)
  • The Best podcasts For Kids (Wired)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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