As August comes to a close, I like to reflect on some observations and perspective gained through casual conversations with friends, family, and strangers on time away from the day-to-day data mining and office grind. I jot down notes of comments that I hear over the summer. Honestly, I feel like I learn more just watching life around me and listening to people talk than I do reading through piles of technical financial reports. These are my observations in no specific order with personal opinions regarding expected resolutions.
Return Expectations Are Very High
When conversations turn to “what do you do”, and I reveal that I am in the wealth management business, I often get an earful. If I had to summarize, the consensus is that stocks will not go down more than 10% (before the Fed steps in to save us) and that returns for next year will easily be double digits.
“ I think the rest of the year should be pretty easy.”
“Markets won’t lose more than 10%, the Fed has our back.”
“I only invest in things that make 15-20% a year.” – my favorite
Indeed
Jared Dillian of the Daily Dirtnap posted the results of investor surveys showing that investors on average expect a 14% gain in 2022. It’s so nice when data and conversations tell the same story.
My Opinion – Forecasting returns is big business for some, but not our firm. We are trend followers and accept asset class trends as they come and avoid relying on dependent variables. However, human nature is one of the few things we can depend on when it comes to investing. We silly creatures have operated under a nearly perfect inverse relationship between expectations and outcomes regarding market returns for as far back as stock market data exists. When investors are bullish with crazy high expectations as they are now, we know with high probabilities that the market is unlikely to produce those results. The opposite holds true at major market lows when expectations for future returns are bleak and negative as they were in March of 2020. So, for this bettin man, I’ll take the odds that the markets are not going to produce 14% until we see prices reset to more attractive levels. I’ll also take the odds that our first pullback of 10% will not stop at 10%. 2021 should still be a good year, it already is. But corrections eventually happen and they do create new powerful return and wealth creating opportunities. I look forward to both… in 2022.
Real Estate
Oh my, everyone wants to talk about real estate.
“I can’t believe how much my house is worth.” or
“My neighbor sold his house in 1 day for 10% over asking price.” or
“It’s just crazy what’s happened to real estate.”
“We are buying a bigger home because rates are so low.”
Yes, yes this is what real estate does when borrowing costs are at 3% for 30 years and inflation is running hot at 5-6%. Add the fact that we have a new generation of Millennials who are buying their first homes, sprinkle in some pandemic recognition that you can work remotely from anywhere (why not move to some place great!) and finish it off with a national housing supply shortage. Voila – prices go up 20-30% year over year! Nothing crazy, it’s just supply and demand.
But there is a new conversation creeping in – carrying costs for housing are also rising sharply.
Carrying costs are those pesky expenses that surround home ownership, like mortgage interest, taxes, utilities, landscaping, a new roof, replacing a washer/dryer, snow removal, etc.
Anecdotally, a neighbor rents a vacation home for the summer months. Last week she learned that her leach field would need to be replaced and that her property taxes were going up 35% from the last tax assessed value. She was very upset. These additional costs were going to erase nearly 3 years of rental income (net of expenses). Nothing about owning a home is cheap anymore. As house prices rise, so too do the costs to maintain and carry them. Bigger homes have bigger costs 1:1. There is no economy of scale in real estate maintenance costs.
We also know that mortgage rates have stopped falling and may be turning up as the Fed talks more often about tapering their stimulus measures, even increasing rates in 2022. Mortgage interest is not a variable cost for most but a new and potentially higher cost for the next buyer.
My Opinion – I see a lot of people buying a lot of real estate and paying some very high prices, carrying mortgages that I can’t imagine. I don’t like the set up for real estate from here. If mortgage rates go up beyond 3.40%, real estate prices will fall regardless of the favorable supply and demand stats.
This is perhaps one of the most interest sensitive real estate markets I have seen in my career. Forbes agrees https://www.forbes.com/sites/billconerly/2021/07/27/the-end-of-the-housing-boom-will-be-when-mortgage-rates-rise-in-2022/?sh=f7cb1e56770b
Strange as it might seem, I would also expect rising carrying costs to become a source of selling pressure especially for rental property owners who have been hurt badly by the 18-month rent moratorium which ended today with a vote by the supreme court.
Supply of homes for sale should rise from here, while demand for new homes at these prices should fall. These trends are already happening in certain locations, with price gains tapering or even falling. With that said, any pullback in prices while rates move higher should present the next great opportunity for buyers. Be patient now and keep saving for that home. 2024 would be about right if I had to guess.
As I have written about before, there is an easy way to own real estate without owning the hard asset and still collect the healthy income. https://allseasonfunds.com/reits-or-rental-property/
Frustration With Summer Chop in the Markets
There is clear frustration with the market performance since last spring.
“Nothing I have is making money.”
“I’ve had it with my bonds – I’m going to sell them.”
“It seems like my portfolio just goes up and down the same amount every month.”
Our client portfolios are experiencing much of the same, no big movements up or down for several months now.
Bonds or any fixed income investments are now posting losses on a total return basis over the last 12 months. The 10-year US Treasury bond is down -4.15% including all interest payments since the highs in August of 2020. Investors are noticing.
“I feel like I should be doing something different with my bond money.”
Of course, losses in the bond market presents a bigger problem. Retirees, risk averse investors or anyone who uses bonds as a risk control tool are now facing a challenge. They must either accept the underperformance and stick with their allocations or make a big jump toward risk assets like stocks.
My Opinion – Investors need to remember that no asset class goes up in a straight line. There are times like these when we need to stay patient and wait for a definitive trend. I can’t say with confidence that the current trend in stocks is either up or down. It’s just choppy. Considering the gains off the lows of March of 2020, I think we should all be VERY thankful that we’ve only seen sideways chop so far. I would have expected a sharp round of profit taking after that run but investors seem willing to ride this bull and give it the benefit of the doubt. So far, a few months of sideways chop is not a painful experience beyond the wait.
On the bond thing – Bonds have traditionally served us well in providing gains and income when stocks are falling. For as long as inflation is running hot as it is today, bonds are not going to provide that service and function. They will just gradually lose money as they have been for over a year. Arguably, there was a time to reduce bond exposure 12 months ago – as we did for our client accounts. Bond prices were hitting all-time highs while stocks were still deeply discounted from the COVID wipeout. Asset allocators would use that time and place to rebalance from bonds to stocks and commodities. Few did but that was the optimal time to do it. Today, bonds are becoming more attractive as prices are falling and stocks are becoming less attractive. We could even argue that a prudent asset allocator would begin moving money from stocks TO bonds now. Again, few will do so. It’s hard to add to something that is losing and reduce exposure to something that is winning.
Our positioning to bonds is very small (15%) by historical standards (~40%) and we have no plans to add to bonds until we see a definitive top in stocks and commodities. We are still in an inflationary cycle that could become problematic if the Fed doesn’t end their over easy policies very soon. Inflation is bad for bonds, good for stocks and commodities. We are in year one of this cycle and have no idea how long we can expect inflation to be with us. No doubt, investors in any income model are a bit frustrated now at the lack of returns over the last year. If your financial plan is accepting of a smaller bond position, it’s not wrong to make a change. If not, stick to your plan, and be patient. Frustration should never be a reason for making a change to your prescribed asset allocation.
Let’s leave it there for today.
I hope everyone is enjoying the last bits of summer – boys are heading back to school/college this week. Sad to see them go as always.
Sam Jones
