Given the popularity of our weekly Market in Pictures, we thought it made sense to pick out a few and go into more detail with our PMs. In this edition, Dave and John Luke will spend a few minutes on each of the following:

• Equal-weighted S&P 500 vs. Cap-weighted
• Zweig Breadth Thrust Signal (ZBT)
• Latest Inflation and rate thoughts

Hope you enjoy, and please send a note to info@apt.us if there’s a particular chart/topic you’d like to see covered next month. Time to swing it around!

Full Transcript

Derek:

Just at the end of November here, coming back from Thanksgiving and wanted to do our monthly recap of some of the charts that we’ve put out there over the past month. Got Dave Wagner here, CFA and equity-focused PM and John Luke Tyner, CFA and fixed income focused PM. And I’ll read our disclaimer, which is the opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus’ investment advisory services can be found in its form ADV part two, which is available upon request.

So what we’ve been doing these past few months is just going through some of the more interesting charts. And maybe ones that… Maybe just to give a little more depth on actually what’s being said on the chart. And then how that plays out going forward, what that actually means. So one of the three that we’re going through is just talking about the average stock. I mean, everybody’s talked about Mag Seven over and over and over again, but what does it mean for the rest of the market and what does it mean for portfolios? I don’t know if one of you wants to jump in and kind of walk us through. We’ve got two charts on this page. One more of a shorter term, one more of a longer term. So maybe give us a little walkthrough here.

Dave:

Yeah, I think we’re all probably hoping that the market becomes what in our idea, a little bit more rational that it’s a market of stocks, not just a stock market. And I know that we’ve probably beaten this horse dead just a few times talking about the Mag Seven, which continuing to drive return. Which I think is somewhat warranted this year if you actually look at a lot of the earnings per share growth for the Mag Seven stocks, a year over year basis. But this top chart is just showing you that only 26% of the stocks in the S&P 500 are outperforming the S&P 500 just this year. And that this is the most concentrated the index has ever been from a market return standpoint. And I know that we’ve continued to have a lot of commentary out there taking a small style tilt into more your S&P 500 equal weighted portfolio, or strategy, pardon me.

And that’s just the same exact 500 stocks that are in the S&P 500, but they’re not market cap weighted. They’re actually equal weighted. And when you look at the valuation between the two, they still tend to look pretty palatable, the average stock. I mean, I think the equal weighted S&P 500’s trading net 2024 earnings just sub 15 while the S&P 500 is trading closer to just above 18.

And I think, one of the big stats that why we continue to want to talk about this because it’s kind of going unheard of in my mind, at least if you listen to anywhere on TV. It’s that the average stock in the Russell 3000 is down 28% since it’s 52 week high. That another way, I think it’s about 53% of the stocks in the Russell 3000 are still down more than 20% versus their 52 week high. So you’ve seen a lot of pullback in the average stock for a continued amount of time. I mean as of today, the S&P 500 is up over 20% and the S&P 500 equal weighted portfolio is only up about 5% showing about a 15% relative spread right now. So it continues and we saw that just this month. I mean the S&P 500 yet again beat the RSP 500 so far here in November.

John Luke:

Yeah, and I don’t know that it’s really an indicator that it’s going to flip immediately, but you have to look at that bottom chart and know that a equal weight’s actually outperformed cap weighted over time. And while this valuation gap and performance gap is stretched, we do think that equal weight can provide some compelling diversification for portfolio construction. And that obviously makes sense because we’ve dotted in most of the portfolios.

But I do think that a more palatable way to sort of get involved in the market is the equal weight S&Pif you’re looking for market type of exposure. And it does give the opportunity for maybe some sort of mean reversion that could play out but still giving you a decent entry point given those valuations that Dave spouted off.

Derek:

I would also say, just my reading of this, you can look at this top chart in a couple of different ways. I think the bottom chart is pretty clear in that over the long haul, these really shouldn’t… You shouldn’t see a big divergence. It’s the same. It’s 500 stocks, it’s not… Or 504, whatever the number is. But it’s not something where you’re going to see decades of a major divergence between what the typical stock does and what the larger cap weighted stocks do.

But one thing you can do if you have a bearish till, you can extrapolate and say, “Oh well late nineties we had this kind of narrow market and the market crashed in the.com bubble.” But I mean that’s one. You have sample size of one. I think that the clearer picture to me is that this entire graph going back almost 30 years, you’re generally in that 45 to 55 range almost every single year other than this year and two others, three others, are basically saying you’re going to have around half the stocks do better, half the stocks do worse.

That can either flip to mean the broader market’s going to catch up to the upside or the big mega stocks are going to come down to the downside. So I think it makes sense to have… Take a longer term approach, not really make a whole lot of predictions out of it, but just recognize that this year has been highly unusual and hopefully to your point with the valuations getting better on the 74% that haven’t beaten the S&P 500. Maybe that sets up for a little bit better year on the broader market.

John Luke:

Yeah, I think bottom line for people that are contributing monthly, probably pretty exciting time to be buying equated S&P.

Derek:

Yes. Perfect. All right. Another thing we’re going to go through, this is old school. I see the name Zweig. I know everybody knows Jason Zweig, Wall Street Journal reporter, who’s great writer, who’s great. Marty Zweig. For those of us that used to watch Wall Street Week, I mean he was a legend back in the day and he was on in the late eighties and I think he was Liz Ann Sonders’ first boss, who we all know is like the Schwab strategist now. She does great work.

But he was the one that really came up with the terms, don’t fight the fed, don’t fight the trend. Things that really have persisted over the decades. And so I see the name in there. I don’t know if one of you wants to go through… What are we looking at? I see a lot of green on here. So what is this? What are you showing us?

Dave:

I’ll take first stab John Luke. And what this is, this is a Zweig market breath indicator in a nutshell. It’s just a momentum based indicator. But for those more math nerds at home, it’s basically calculated by taking the 10 day moving average of the number of advancing issues divided by the number of advancing issues, plus the number of declining in issues. That’s a lot of mumbo jumbo that I basically said there. But in a nutshell it’s just a measurement of momentum. And what this is just stating is that this past month, in my mind, I would consider this to be more of a right tail event because I don’t think many people heading into this month thought that the S&P 500 could go up 9% to the tail of it being up now 20% year to date.

But what it’s just showing is, when that Zweig market breadth, the thrust. That’s hard to say. I apologize. Signal gets triggered. It’s only happened a handful of times since World War II. It tends to continue strength of the market as a whole. And if you compare that really to our last slide of just showing that, “Hey, you know what the average stock is in a technical bear market right now.” Kind of what Derek said there, “You can either see the average stock regaining its footing or seeing the Magnificent Seven losing its footing.” Or I guess, you could have both of those situations happen.

But there’s still a lot of opportunity out there in this market to remain bullish, even though I think you’re getting a lot of sentiment out there is quite bearish on the macroeconomic front. It just shows the importance of having the right structure in place at the asset allocation level that you could still want to participate in these right tail events, much like what we’ve seen this year.

John Luke:

And you look at that chart and you’ve got a couple dates in there that are pretty familiar. So like the forties inflationary period with the market sort of ramping off of that. Again, the seventies and early eighties period where market was very friendly. And then obviously after the financial crisis and some of the QE times where markets have really rallied since following the financial crisis broadly.

But I think, the other sort of maybe tinder on the fire could be sort of the money market allocation that we’ve seen. I think there’s somewhere between five and $6 trillion that’s flowed into money markets over the past year or so with rates higher. And I do think that there will be some sort of indicator where it took rates to get to about 4% where before depositors started pulling money out of banks and then chasing money markets and T-bills. Where if rates were to fall back lower, I think that you could have a lot of dry powder on the forefront of things where if rates do move lower that stocks could have another sort of jolt forward with just money getting shifted around back into risk assets.

Dave:

And I think John Luke, I think one thing that JD says really well when talking about our asset allocation, he talks about the impact of returns are more important than the frequency of returns. So you got to prepare for the left tail situation and also the right tail situation. But I read a pretty interesting fact showing that these right tail situations, much like what we’ve seen month to date with a market up about 9% here in November so far, is that if you look at the S&P 500, the percentage of advances each year. When the market’s up 20% or more in a calendar year that’s happened 36% of the times dating back to the 1930s. Market is up about 21% of the time between the range of up 10% to up 20%. And if you look at a market that’s down 10% or more over a calendar a year, that only happens about 12% of the time. So it just really shows the impact is very much more important than the frequency, not just on the downside but also the upside.

John Luke:

Yeah, I think really the only other point that that is maybe obvious. But market’s flat for the past two and a half years or relatively flat. And I do think that maybe that catch up or adjustment period has been playing out, right? Stocks are nominal assets where they have the ability to grow their earnings and grow their pricing power and things like that that give them levers to offset just the cumulative cost of living, which will ironically be the next slide. But I do-

Dave:

No, I was just… Sorry to cut into you there. But John Luke let’s just put ourselves in the seat of a lot of the advisors, our different partners on this call. I mean their clients always says, “What have you done for me here lately?” And you brought up a great point, JL. “Hey, market’s up 20% this year, but if you look at my returns over the last two years, they’re flat.” But it’s, “What have you done for me here lately?” It’s like, all right, market’s up 20%, we’re still flat over the last two years. It puts a lot of advisors and some of our partners in some very difficult conversations right now.

Derek:

So on that point that JL was going towards and the fact that not only are markets pretty flat, but costs have risen in pretty much every category. And while they may not be spiking like they were, they did hit pretty hard for a couple years. And it’s not like when inflation comes back to 2%, it doesn’t mean prices are falling. I mean, it just means they’re stable at a high level. So maybe there’s a lot of small numbers and different lines on here. You want to walk us through a little bit of this.

John Luke:

So this chart looks back to the beginning of March 2020, sort of the forefront of the inflationary period following the pandemic and the lockdowns. So what it’s looking at, the green line is CPI, food at home, the blue line is CPI, all items. And the orange line is CPI, commodities, X food and energy. So basically, a core type of measure. And really what it’s starting or what it’s showing is just how high that inflation has gone up the last call at three years. Where the cumulative impact of inflation is what’s really starting to be felt by the consumers where, like Derek said, you’ve seen inflation slow down. Like this time last year inflation was pushing on double digits and now we’re back near three.

But the real impact is that the price of everything has gone up pretty drastically and that doesn’t really spare the consumer much relief whenever that inflation does peak its head a little bit lower because you’re coming off of such a big base. And I do think that how this relates to clients’ allocations is, this is longevity risk front and center. And the impact of cost of living, which arguably these numbers are probably understated to most budgets for folks living in the real world. But if you’re looking at the numbers, cumulative inflation of CPI all items is up over 20% in three years. That’s a pretty substantial impact of just the price of things and what that’s costing. And I think it really bears the need of making sure that we have enough risk in client portfolios and the overweight of stocks that we position in our allocations.

Because really you’ve got to have assets that can grow and while you get maybe a 2022 environment where everything’s bad and there’s really no place to hide, that’s really part of the investing journey of just as things happen. And I think, it just makes a point of trying to position the best you can to get and inject enough turn drivers into portfolios, enough growth into portfolios that really allow you to isolate from some of the impacts of cumulative inflation and cost of living.

And just a simple reminder here on the right side, fixed income and a rising cost of living environment is detrimental. Your G or your growth on fixed income is zero, but cost of living, we kind of laugh when we show charts that show a straight up like this cost of living. But you look at the cumulative one on the left and it’s pretty similar. And I do think that the allocations and how we’ve built portfolios will over time help deal with this factor.

Dave:

So as everyone knows, I always have thoughts on everything. But I’m not going to say them here because what John Luke’s talking about here in this situation with inflation. But more importantly, talking about its effect on an asset allocation level. It’s like the most utmost important thing you can take away probably from this three pointers. So if I was y’all listening instead of listening to me to talk for about a minute, I would just rewind the last two minutes and re-listen to what John Luke just said there. ‘Cause that is the most important talking point that a lot of y’all can have with your own clients.

Derek:

Well, and I think you’re tying back into that money market quote. When you look at that graphic on the right, the fixed income is not a compounding asset. I mean it’s an income asset. Like you said, it’s 0% grower inflation compounds, even when it’s low, it compounds like stocks do. And so there has obviously been a race into money market funds and people are just giddy to get five and a half percent and sit there and collect that without risk.

But there is that silent risk that when you get the crossover like that and the compounding of inflation takes place, I mean you got one of two things. If rates go higher, then your cost of living has gone higher, your expenses have gone higher, and you’re kind of falling behind from that side, if you’re locked into fixed income. And if you’re in money markets and rates go down, now you have a reinvestment risk where, “Yeah, it was cool, I got five and a half percent for a year or two, but now what if rates are 4%, 3%, 2%?” It’s not as exciting anymore and you probably have missed out on other opportunities.

So I think it’s important to kind of balance all that out. And that’s where these guys do a ton of work at the allocation level to make sure that, “Yeah, we’ve got enough safe capital. We’ve got enough growth capital. We have the income side taken care of.” So I don’t know if you guys have anything to add to that, but that’s kind of what pops out at me when I look at… You’re right though. It’s almost like this left graphic is showing a microcosm of the right graphic.

John Luke:

Yeah. And one trivia question for you, Dave, is inflation, when you get a cycle, does it typically just end after one wave higher or are there more oftentimes multiple waves? And I guess to put that in context, there hasn’t been a ton of samples, but we have… There is an answer.

Dave:

Well, the answer’s binary here, John Luke. It’s either yes or no. And we both know that answer. It tends to not just stop at one cycle of inflation. So hit us with those numbers.

John Luke:

So from studies that I’ve seen, about 87% of the time, it doesn’t end at one phase of inflation or one cycle of inflation. Typically, there’s two or three. And while phase one is obviously probably over with, I do think that you can’t overlook the fact that what if the Fed backs off too early and we do get some sort of re-ignition in inflation? And I think it just sort of compounds the point of making sure the asset allocations are built properly.

Dave:

Hey, John, Luke, if you could give a letter grade to Jerome Powell for how he’s handled this situation, what would you give him? What letter grade?

John Luke:

I don’t want to comment on that. I think he’s done a pretty good job the last 18, 20 months.

Derek:

He was behind after the first midterm, but he got-

John Luke:

Jerome was first and he’s probably gotten a B plus or A minus sense.

Derek:

Whoa.

Dave:

That’s higher than I would’ve thought, John Luke. I would’ve thought you’d said B minus or C plus. I’m probably rating the B plus A minus camp also.

John Luke:

Yeah, I mean we could spend another… We’ll turn it into six pointers.

Derek:

All right guys. Awesome. Thanks for running through it and hope everyone gets a lot out of it. Remember, fire away questions. If you have ideas for next month, we’re always up for it. So appreciate you guys helping out with this.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security.

The opinions expressed are those of the Aptus Capital Advisors Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed.

Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call (251) 517-7198. ACA-2311-18.

Given the popularity of our weekly Market in Pictures, we thought it made sense to pick out a few and go into more detail with our PMs. In this edition, Dave and John Luke will spend a few minutes on each of the following:

• Portfolio performance with equal-weighted S&P 500 vs. cap-weighted, driven by the “Mag 7”
• Bonds not acting as diversifiers OR hedges, which happens sometimes!
• Latest selloff driven by valuations, not lack of growth

Dave was at the farm and had two short bouts of a weak connection, but we fought through it and think you should too. The goal is to run these live, on one take…as an actual convo with you would be.

Hope you enjoy, and please send a note to info@apt.us if there’s a particular chart/topic you’d like to see covered next month. Time to swing it around!

Transcript:

Derek:

Hello, Derek here from Aptus. It is Friday, September 1st going into Labor Day weekend and we’re doing a new little segment that we’re going to try to do every month where we just go through some of the charts that have been prevalent on some of the threads and discussions internally. Really just dig into them a little bit where we think they might have relevance to portfolios because ultimately that’s all that matters. There’s charts that are noisy and there’s charts that actually may have either a signal or a conflict inherent to them. I thought it’d be good to bring a couple of these guys in. They’re going to have some things where they sit on both sides of the debate.

I do need to read a disclosure. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus Investment Advisory services can be found in its form ADV part two, which is available upon request. If you’re a client, these guys, Dave Wagner, at least on the top of my screen, CFA, and really our equity guy. John Luke Tyner, who is also a CFA and really our fixed income guy, but they really cover all things macro. If you’re a client, you’ve talked to each of them probably multiple times and each have strong opinions and put in a lot of time on thinking through some of these topics and how it impacts allocations.

We all love football, but I think with the basketball pedigree in this firm, it made sense to go with three pointers where we’ll just go through three charts that are seem to be relevant right now and just hit them and see what these guys think. Part of this will be us teeing up the questions, but in the future there could be, we may pull in advisor ideas to say, “Hey, walk me through that chart, what does it mean?” If we get a couple of those requests, like those would be perfect for this format.

Anyway, I will start the first one that has been a pretty heavy discussion point. We all know there’s been a little bit of a change in the fixed-income correlation versus equities, but in particular what really doesn’t get discussed as much as real yields. Everybody sees what bonds yield, but we haven’t talked as much about real yields. Historically real yields at a higher level have been a little bit of a competition for stocks and would seem to put a little bit of a ceiling on valuations. We’ve not seen that all in the past year after having years of extremely low real yields or even negative real yields. We’ve seen real yields spike up quite a bit and become competition, but valuations haven’t come in much. Any thoughts there from either of you?

Dave:
Yeah, I’ll take that. This is a really cool idea walking through a few charts here. You’re going to get the raw thinking from John Luke and myself. We spend 10, 20 minutes a day on the phone with each other, just bantering back and forth with what we saw in the market, what we’re focusing on and what our takes are. We wanted to show that to everyone on this call listening what John Luke and I really do behind the scenes to really come together with some type of cohesive thinking.

This is a really interesting chart because given recency bias of 2022, we saw real rates continue to rise and valuations were hit. That’s the inverse correlation you would expect. Yet that hasn’t really been the story this year as real rates have continued to rise, but they have been positively correlated with the valuation. If you look at this chart on the left axis over there, it’s showing you the valuation on a forward basis over the next 12 months for the NASDAQ 100. What we’ve seen basically since the end of 2022 and early 23 via the red dotted line that valuations for the NASDAQ, well, it’s continued to go straight up into the right.

If you look at the blue line, and this is where the chart gets a little bit confusing, this is actually the inverted US 10 year real yield, and that’s showing on the right axis there. It’s actually going in a downward sloping fashion, but since it’s inverted, it’s actually showing that real rates are continuing to go up. That’s been pretty heavily correlated with the valuation and especially the higher value tech sector. You’ve seen this divergence [inaudible 00:04:37] and it’s really caught our eye, and I think it goes back to a lot of our commentary on has the market taken off that right tail risk of interest rates, allowing valuations to continue to increase given what happened back in March with all the banking aspects with the Fed stepping in, increasing their balance sheet to not bail out these banks but in a way bail out the banks.

Between that and the aspect of the market really not believing that rates are going to remain higher for longer basically has allowed valuations within the tech sector to continue to increase. When it comes back down to a portfolio allocation perspective, what we’ve been saying for quite some time is now that rates on the two year and ten year are back to where they were back in [inaudible 00:05:19], when is the market going to reintroduce this right tail of interest rate risk into the market? What that means is if rates stay higher for longer and the market starts to believe that, don’t you think valuations [inaudible 00:05:31] should really start to come down. We want to make sure that portfolios are positioned if that is the case moving forward.

John Luke:
Yeah, I think it’s a great point. When you think about real yields, it’s just the nominal treasury yield less inflation. There’s two ways that real yields can rise. Number one is just nominal yields rising and inflation staying flat, but then also it’s inflation going down and nominal yields staying flat. What we’ve seen this year has been really a mix of both where inflation’s come down significantly and nominal yields have risen, and so it’s artificially pushed real yields higher just due to the extent of how much inflation has come down. I think it’ll be interesting to see moving forward how real rates will react if we see inflation stay stickier in this 3% range.

Again, you would think that now that there’s an alternative where positive real yields are a great thing for savers because now they can actually put their money in something and have a safe return that’s positive in real terms. It will be interesting to see if the valuations can stay this elevated on a particular group of stocks that we’re very familiar with.

Dave:
Well, John Luke, what do you think about, people think in terms of nominal yield, but they eat real yield, you see that as a pretty big problem for overall portfolios if that mentality continues?

John Luke:
Yeah, and I think one of the interesting pieces is this move higher in real yields could be somewhat offset with just expectations of inflation being higher in the future so maybe the real yields aren’t necessarily as high as they look. I think that in an inflationary environment, the challenge for asset allocation is just making sure that you have enough things in the portfolio that are tied to real growth that can offset the inflation. Ultimately we can’t really affect whether inflation is low or high, you just have to flex your portfolio with what’s going on at the time.

Derek:
Awesome. Well, we are going to try to keep this moving along. That’s good though. I want to be able to cover each of these in a couple of minutes and make it something where once a month we can send this out. It might be less than 10 minutes, but provide a lot of punch for viewers. Another topic that pretty much anyone viewing this knows on the consumer side, if you have a mortgage and it’s pre-2022, you already know that you’re happy. You’ve got that two and a half, 3% mortgage, and if someone came to buy your house now, they would not get that mortgage. They’d be paying double, triple that number. It creates this massive disparity between current homeowners and prospective homeowners. We’ve seen it in really no homes for sale, especially in the existing home market.

I think what is less discussed is what are we seeing in the corporate world and what are we seeing at the government level? This chart’s pretty striking I thought that corporations they’re sitting pretty like consumers are. Feel free to walk through a little bit of what you see here.

John Luke:
Yeah, I think it goes back to 2020 and 2021 where just internally at Aptus, it seemed like every day that you were seeing companies issue debt 20, 30, even 40 years at rates that were just unbelievably low. I think what you’re seeing is the aftereffect where this chart specifically on the right-hand side just shows that more than or nearly half of the S and P 500 debt outstanding is due 2030 or later. A lot of that is well past 2030.So you’re talking 20 or 30 years out. Really if you think about an inflationary type of environment, the best thing that you can possibly have is cheap fixed debt and then inflate away the value of that debt over time.

Effectively that’s what you’re seeing at the company level or at the corporate level where these companies actually were very responsible, maybe seemed irresponsible at the time, but responsible in terms of stewarding shareholder value by extending the duration of the debt really long and locking in low borrowing cost. Really what you’ve seen is a less interest rate sensitive economy, especially for these large companies that could lock in long duration debt where a rise in rates it might affect people that have short-term borrowing where they have to refinance higher at higher rates. For the most part, many of these companies, they don’t have that problem frankly.

Dave:
It’s not something I think that’s just going to switch overnight. What this is showing here in the chart, like we said, John Luke, 46% of the outstanding debt is due after 2030. A Lot of these companies have weighted average cost of capital like 2%, and they’re sitting on a huge balance sheet worth of capital where they’re getting like 5% right now. It’s not arbitrage, they’re just clipping the spread. If you just look at Apple as a company as a whole, I just brought up a tear sheet on them. They have like $62.48 billion in cash right now, and that’s just not sitting [inaudible 00:10:45]. They’re obviously getting some type of yield here in that a quarter right now. I just think that the tailwinds just given the spread that I do believe that rates are going to remain higher for much longer. The fact how far out these maturities are in the debt, a lot of these companies, especially on the large cap side, are just going to be clipping money for quite some time.

John Luke:
They’re banks at this point.

Dave:
Oh yeah.

John Luke:
Right. Borrow low and lend high.

Dave:
I would love to try to figure out the interest. Sorry, John Luke, go ahead.

John Luke:
Yeah, it’s something that I think will drive earnings more than most folks realize is that these companies have so much interest income that they’re receiving in a positive sense that it can insulate a lot of volatility in the economy.

Dave:
Even if you look like Morgan Stanley’s Mike Wilson, this was a big thing that he was hitting against for quite some time, was that leverage is going to start hurting these companies substantially and that’s going to decrease margin, which should decrease the absolute valuation of the company and the market as a whole. We just haven’t seen that whatsoever. That was actually put out in [inaudible 00:11:48] that I did one or two weeks ago. The fact that the interest that’s coming in is substantially higher than the interest expense going out.

John Luke:
Yeah. It goes back to that last chart with NASDAQ valuations with the companies that are making up the bulk of the NASDAQ or the ones that have a lot of this debt after 2030. I think it doesn’t necessarily rationalize the multiples, but it makes them a little bit more tolerable when you put it in that context.

Derek:
Yeah. It probably breaks a lot of the textbooks that y’all studied back in the CFA that when you do go into a rising interest rate environment and companies that have short-term debt have to refinance, it hits their margins. I don’t know, it seems like a lot of US corporations milked it pretty good.

John Luke:
Yeah, well, it just gives you flexibility where they’ve got so much time to plan to pay off this debt. Now obviously the carry cost is low, but they’re going to be paying it off with massively inflated dollars and they’re going to have a whole lot of time to plan on how to extinguish it.

Dave:
I think that’s actually a huge positive for active stock pickers too, because exactly what you said there, D. Hern, what has history told you? It’s like I leverage on balance sheets, it’s binary, it’s bad. You want lower absolute leverage on your balances. Well, now you have to think about it from a qualitative aspect. What do these management teams do to look through that windshield of where they believe that rates are going to be moving forward to position their balance sheet for as much operating leverage as possible? That’s not something that could be computed by some type of computer or some type of tilted factor exposure through a passive smart beta type of ETF.

John Luke:
Yep. The last comment I’d make is the personal finance balance sheet of consumers is about in the same position as this. They’ve locked in a lot of long-term expenses with their mortgage payments being low and they’ve got pay increases and wage inflation that’s benefiting them and giving them more money to spend into the economy today. That’s what you’ve seen the last really year where everyone’s been so gung-ho that the recession was imminent and they just didn’t bake in the benefit of locked in low interest rates for the terms that we have in place right now. Obviously someone owns all of this debt, but it’s less sensitive because it’s locked up to banks and Fed balance sheets and things like that.

Dave:
I wouldn’t say that on the consumer side versus the corporate side that they’re on the same exact level. I think a lot of the data that we saw come out earlier this week on consumer spending, they continued to do, I forget who coined this term, it’s like YOLO spending this summer. I mean, it’s brought down their savings rate to three and a half percent right now. That’s substantially below long-term average savings rates. They are really dipping into their balance sheet, their war chest of capital a lot more I think than what corporations are. When you take that information and move it towards, what does that mean for the market?

Well, the S&P 500 tends to be more of a goods oriented type of exposure while GDP tends to be more heavily on the services side and the consumer side because two-thirds of GDP is made up of the consumer itself. That shows that you could continue to see some type of strength at the S&P 500 levels just because all those corporations tend to be more goods focused. That could be a pretty good investment of just owning some type of cheap beta in the S&P 500.

Derek:
Let’s talk about who did not take advantage of the low interest rates.

John Luke:
[inaudible 00:15:27] hundred year debt offerings?

Derek:
A huge missed opportunity it seems.

John Luke:
Yeah. I know that we looked at issuing some 50 and hundred year paper back at record lows and decided against it. Yeah, it’s certainly concerning in terms of where the Fed’s debt maturity profile is right now. Then also if you think about where they’ve been doing a huge bulk of the issuance lately has been at the front end of the curve, and that’s obviously been to protect the liquidity profile of markets. If you issue at the front end of the curve, that’s the least market impactful as far as draining liquidity from markets. It’s also the most expensive.

As governments and specifically the US government continues to refinance this debt from the low 2% level that we started at when we came into this rising interest rate mess to five and a half percent type of short end rates, it’s definitely having an impact on the fiscal situation of the US. Right now we’re running roughly a 9% deficit, and that’s with 3.8% unemployment. You’re running basically crisis or war level deficits with a “really healthy, strong economy”.

Dave:
I think one of the [inaudible 00:16:50] that when I look at this chart, John Luke, is there still going to be an arm’s length distance between the Fed and the government as all, or is the US government going to try to strong arm the Fed to decrease rates here? That’s why they’re obviously issuing the front end of the curve so they can reinvest once those roll off at lower rates because the government doesn’t think that rates can stay this higher for longer. All the data, I think to all the listeners who continue to listen to us, however far we are in here, all the data that John Luke and I always talk about is that rates should be higher for much, much longer. Is the government going to pressure Jerome Powell and the Fed, even though they’re not supposed to, into jawboning them into actually cutting rates sooner than expected so they can get this interest expense rate down, especially heading into an election year right now?

John Luke:
Yeah, I think that there’s certain ways that they can be a little bit more sneaky about it, like raising capital requirements for banks and doing other subtle forms of yield curve control where they hopefully keep rates to something sustainable. Ultimately, I think that unless the Fed is back involved in buying a lot of this issuance that they’re going to have to keep rates high in order to keep the demand there.

Dave:
If you think what happened back in March, I think everyone only thinks that the Fed, and maybe the US government thinks this too, they only have one lever to pull and that’s to decrease interest rates. That’s not the case. Look what happened back in March when all this banking crisis started to go on the Fed increased their balance sheet, they didn’t cut rates whatsoever. I think if you do see some type of crisis in the near future, I think the Fed is going to utilize a lever that they haven’t historically been able to do, and that’s to increase the size of the balance sheet without cutting some type of rates too. That definitely doesn’t help the US government whatsoever if something does happen.

John Luke:
Yeah, Fed’s balance sheets just creeped below 8 trillion, was a little over 9 trillion to start, so it’s certainly declining. The first trillion roll off of the balance sheet has been fairly smooth, but it’s going to be tough to see them really shred this thing down. If you look back at the FMC minute meetings from the last meeting, they’re pretty imminent that the balance sheet needs to continue to shrink. They’re certainly trying to go down that avenue. It’s just a question of will they be able to, and I guess last point is when you’re running a 9% deficit, that has to get funded somehow, and that means more debt issuance and someone’s got to buy all of it. I think that’s really what you’ve seen the last couple of weeks where rates have shot up higher.

Dave:
Correct me if I’m wrong with this number, John Luke, I’m probably just throwing out a random number. Every $100 billion worth of balance sheet reduction equates to 10 basis points or 20 basis points of interest rate hikes in a way, just from what it’s doing from a tightening perspective.

John Luke:
Yeah, that’s roughly the number that’s quoted. Just not sure the effectiveness because it’s the saying whenever you overuse one of the components of your tool that it dilutes the impact of it. I think we’ve probably seen some dilution.

Derek:
All right, I’m going to hop on one more chart, which has really been the story of this year in particular. Everyone talks about the market being expensive and maybe there’s a ceiling if we’re at 20 times earnings on the S&P index, but especially Dave as you know from studying individual stocks at all capitalizations, there’s a pretty wide range of where things sit. I thought we’ve seen this in a couple of different forms, but I thought this might be a good one for you to go through a little bit.

Dave:
Yeah, it felt like this year has just been a stock market, not a market of stocks. With that latter comment there, a market of stocks underneath the hood of whether it’s the S&P 500, Russell 2000, Russell 2000 value, our entire equity team is still finding opportunities and stuff that we think that there is value out there. Yes, 20 times future earnings on the S&P 500 does seem expensive. If you look at this chart here, it’s showing that the S&P 500, or basically the magnificent seven are trading at 32 point times [inaudible 00:21:16] forward earnings, but if you look at the average stock itself, it’s trading closer to 16.8 times.

That’s a lot more palatable in my mind. That’s why I think we’ve talked a lot about having more of an exposure to an equal weight S&P 500 over a market cap weight, or at least the introduction of some type of tilt to the average stock is pretty important right now. We’re finding a lot of opportunities out there on the individual stock basis and that gives me a lot of optimism I think for the equity markets into the future, even though we’re looking at the S&P 500 trading at 20 times. Like I said, it’s really a market of stocks instead of a stock market probably moving forward.

Derek:
Makes sense. I think a lot of what we’ve seen out of this is people have pinned their hopes on lower valuations. It’s almost, you could also put in the chart on the US versus Europe and versus the rest of the globe. The US has been at a premium multiple for years and people have been burned trying to buy those lower valuation international stocks. You wonder at some point if they’ve just given up and does that set up opportunity. I guess that’s where we sit now. Everyone certainly knows the story.

John Luke:
No, I think that some of these small caps and smaller market capitalization companies where they’re getting exposure to some of this infrastructure spending that’s in place and the re-shoring where maybe that’s being overlooked at the allocation level or where people are allocating dollars because as we move industry back to the US, we re-shore things. We have manufacturing and stuff that’s coming from China, not coming from China, but coming from the US or coming from Mexico, that these companies are going to have to be highly invested in in terms of actually making that happen. I think that is sort of a green shoot for small caps and I’m sure Dave agrees with that.

Dave:
A hundred percent. Here’s where my mind is. My biggest worry for the [inaudible 00:23:26], and I don’t want to open up a whole new can of worms here because we’re probably pressing up on time restraints right now, but it’s exactly what you’ve mentioned there, John Luke, that there is a lot of re-shoring going on in the United States, but it’s very concentrated to a very few [inaudible 00:23:40] state. It’s Tennessee, Ohio, Michigan, Indiana, Texas. You’re not going along the coastlines by any means. When we just spoke about the Fed and a lot of its monetary policy that they’re working on right now in this inflation environment, Fed policy is monolithic. The change that they make at the monetary level, whether it’s on interest rates or whatever they’re trying to pack from a labor situation, it’s broad based across the entire United States.

When I think that re-shoring aspect that we’re talking about here that will benefit small caps, it’s very centralized in a few areas. I think that there’s going to be a pretty big divergence in our country five, ten years from now that not everything is created equal. There’s going to be a disparity amongst geographical regions in the United States where Fed policy may not be as effective as they exactly want it to be because it’s only really affecting a small part of the company as a whole.

John Luke:
Yep. Great point.

Derek:
Awesome. All right, well as everyone knows, there’s a lot of gray, the markets are not as black and white as our services might be, so I’m going to give a plug for some of the work you guys do behind the scenes. Well, you guys and the rest of the CFAs. I think one thing that we’re really, really good at is helping advisors grow, helping them compete for and win and transition and manage high net worth accounts in particular, you guys have both been instrumental in helping someone who’s got a big individual bond portfolio or they bring over an SMA that’s got 200 stocks in it. That stuff’s a pain in the butt for an advisor to figure out from a tax standpoint and just the logistics of, “Okay, great, I can win this $3 million account, but what am I going to do with it? How am I ever going to get it into my models?”

I think I’m going to give a plug, less of a three pointer more of a slam dunk, I’m going to give a plug to if anyone has any of those accounts they’re trying to get or wants to learn more about how we can help with that stuff. I don’t know, I volunteer you guys all the time to help with that stuff and thankfully you take us up on it.

John Luke:
Yeah, thanks D. Hern. Great point.

Derek:
Well that’s good. I think we probably weren’t quite as quick as I would like, but that’s because you guys have good ideas and lots to talk about. It’s good though. I think we’ll do this every month and I would invite advisors to chime in and throw any questions our way that you might want to have discussed. I’ll thank you guys and hope y’all have a great weekend.

John Luke:
Thanks guys.

Dave:
Good day.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security.

The opinions expressed are those of the Aptus Capital Advisors Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed.

Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call (251) 517-7198. ACA-2309-6.

This was a fun exercise, hopefully the first of a monthly series. Given the popularity of our weekly Market in Pictures, we thought it made sense to pick out a few and go into more detail with our PMs. In this edition, Dave and John Luke will spend a few minutes on each of the following:

• The current anomaly between rising real yields and rising equity valuations
• The divergences for debtholders across consumers, corporations, and the Federal government
• Broad market valuations vs. those of the “Magnificent 7”

Not sure why, but halfway through our camera shots froze. But the pics and audio are there so we’ll run with this version, who needs our distracting animation anyway!

Hope you enjoy, and please send a note to info@apt.us if there’s a particular chart/topic you’d like to see covered next month. Time to swing the ball around!

Transcript:

Derek:

Hello, Derek here from Aptus. It is Friday, September 1st going into Labor Day weekend and we’re doing a new little segment that we’re going to try to do every month where we just go through some of the charts that have been prevalent on some of the threads and discussions internally. Really just dig into them a little bit where we think they might have relevance to portfolios because ultimately that’s all that matters. There’s charts that are noisy and there’s charts that actually may have either a signal or a conflict inherent to them. I thought it’d be good to bring a couple of these guys in. They’re going to have some things where they sit on both sides of the debate.

I do need to read a disclosure. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus Investment Advisory services can be found in its form ADV part two, which is available upon request. If you’re a client, these guys, Dave Wagner, at least on the top of my screen, CFA, and really our equity guy. John Luke Tyner, who is also a CFA and really our fixed income guy, but they really cover all things macro. If you’re a client, you’ve talked to each of them probably multiple times and each have strong opinions and put in a lot of time on thinking through some of these topics and how it impacts allocations.

We all love football, but I think with the basketball pedigree in this firm, it made sense to go with three pointers where we’ll just go through three charts that are seem to be relevant right now and just hit them and see what these guys think. Part of this will be us teeing up the questions, but in the future there could be, we may pull in advisor ideas to say, “Hey, walk me through that chart, what does it mean?” If we get a couple of those requests, like those would be perfect for this format.

Anyway, I will start the first one that has been a pretty heavy discussion point. We all know there’s been a little bit of a change in the fixed-income correlation versus equities, but in particular what really doesn’t get discussed as much as real yields. Everybody sees what bonds yield, but we haven’t talked as much about real yields. Historically real yields at a higher level have been a little bit of a competition for stocks and would seem to put a little bit of a ceiling on valuations. We’ve not seen that all in the past year after having years of extremely low real yields or even negative real yields. We’ve seen real yields spike up quite a bit and become competition, but valuations haven’t come in much. Any thoughts there from either of you?

Dave:
Yeah, I’ll take that. This is a really cool idea walking through a few charts here. You’re going to get the raw thinking from John Luke and myself. We spend 10, 20 minutes a day on the phone with each other, just bantering back and forth with what we saw in the market, what we’re focusing on and what our takes are. We wanted to show that to everyone on this call listening what John Luke and I really do behind the scenes to really come together with some type of cohesive thinking.

This is a really interesting chart because given recency bias of 2022, we saw real rates continue to rise and valuations were hit. That’s the inverse correlation you would expect. Yet that hasn’t really been the story this year as real rates have continued to rise, but they have been positively correlated with the valuation. If you look at this chart on the left axis over there, it’s showing you the valuation on a forward basis over the next 12 months for the NASDAQ 100. What we’ve seen basically since the end of 2022 and early 23 via the red dotted line that valuations for the NASDAQ, well, it’s continued to go straight up into the right.

If you look at the blue line, and this is where the chart gets a little bit confusing, this is actually the inverted US 10 year real yield, and that’s showing on the right axis there. It’s actually going in a downward sloping fashion, but since it’s inverted, it’s actually showing that real rates are continuing to go up. That’s been pretty heavily correlated with the valuation and especially the higher value tech sector. You’ve seen this divergence [inaudible 00:04:37] and it’s really caught our eye, and I think it goes back to a lot of our commentary on has the market taken off that right tail risk of interest rates, allowing valuations to continue to increase given what happened back in March with all the banking aspects with the Fed stepping in, increasing their balance sheet to not bail out these banks but in a way bail out the banks.

Between that and the aspect of the market really not believing that rates are going to remain higher for longer basically has allowed valuations within the tech sector to continue to increase. When it comes back down to a portfolio allocation perspective, what we’ve been saying for quite some time is now that rates on the two year and ten year are back to where they were back in [inaudible 00:05:19], when is the market going to reintroduce this right tail of interest rate risk into the market? What that means is if rates stay higher for longer and the market starts to believe that, don’t you think valuations [inaudible 00:05:31] should really start to come down. We want to make sure that portfolios are positioned if that is the case moving forward.

John Luke:
Yeah, I think it’s a great point. When you think about real yields, it’s just the nominal treasury yield less inflation. There’s two ways that real yields can rise. Number one is just nominal yields rising and inflation staying flat, but then also it’s inflation going down and nominal yields staying flat. What we’ve seen this year has been really a mix of both where inflation’s come down significantly and nominal yields have risen, and so it’s artificially pushed real yields higher just due to the extent of how much inflation has come down. I think it’ll be interesting to see moving forward how real rates will react if we see inflation stay stickier in this 3% range.

Again, you would think that now that there’s an alternative where positive real yields are a great thing for savers because now they can actually put their money in something and have a safe return that’s positive in real terms. It will be interesting to see if the valuations can stay this elevated on a particular group of stocks that we’re very familiar with.

Dave:
Well, John Luke, what do you think about, people think in terms of nominal yield, but they eat real yield, you see that as a pretty big problem for overall portfolios if that mentality continues?

John Luke:
Yeah, and I think one of the interesting pieces is this move higher in real yields could be somewhat offset with just expectations of inflation being higher in the future so maybe the real yields aren’t necessarily as high as they look. I think that in an inflationary environment, the challenge for asset allocation is just making sure that you have enough things in the portfolio that are tied to real growth that can offset the inflation. Ultimately we can’t really affect whether inflation is low or high, you just have to flex your portfolio with what’s going on at the time.

Derek:
Awesome. Well, we are going to try to keep this moving along. That’s good though. I want to be able to cover each of these in a couple of minutes and make it something where once a month we can send this out. It might be less than 10 minutes, but provide a lot of punch for viewers. Another topic that pretty much anyone viewing this knows on the consumer side, if you have a mortgage and it’s pre-2022, you already know that you’re happy. You’ve got that two and a half, 3% mortgage, and if someone came to buy your house now, they would not get that mortgage. They’d be paying double, triple that number. It creates this massive disparity between current homeowners and prospective homeowners. We’ve seen it in really no homes for sale, especially in the existing home market.

I think what is less discussed is what are we seeing in the corporate world and what are we seeing at the government level? This chart’s pretty striking I thought that corporations they’re sitting pretty like consumers are. Feel free to walk through a little bit of what you see here.

John Luke:
Yeah, I think it goes back to 2020 and 2021 where just internally at Aptus, it seemed like every day that you were seeing companies issue debt 20, 30, even 40 years at rates that were just unbelievably low. I think what you’re seeing is the aftereffect where this chart specifically on the right-hand side just shows that more than or nearly half of the S and P 500 debt outstanding is due 2030 or later. A lot of that is well past 2030.So you’re talking 20 or 30 years out. Really if you think about an inflationary type of environment, the best thing that you can possibly have is cheap fixed debt and then inflate away the value of that debt over time.

Effectively that’s what you’re seeing at the company level or at the corporate level where these companies actually were very responsible, maybe seemed irresponsible at the time, but responsible in terms of stewarding shareholder value by extending the duration of the debt really long and locking in low borrowing cost. Really what you’ve seen is a less interest rate sensitive economy, especially for these large companies that could lock in long duration debt where a rise in rates it might affect people that have short-term borrowing where they have to refinance higher at higher rates. For the most part, many of these companies, they don’t have that problem frankly.

Dave:
It’s not something I think that’s just going to switch overnight. What this is showing here in the chart, like we said, John Luke, 46% of the outstanding debt is due after 2030. A Lot of these companies have weighted average cost of capital like 2%, and they’re sitting on a huge balance sheet worth of capital where they’re getting like 5% right now. It’s not arbitrage, they’re just clipping the spread. If you just look at Apple as a company as a whole, I just brought up a tear sheet on them. They have like $62.48 billion in cash right now, and that’s just not sitting [inaudible 00:10:45]. They’re obviously getting some type of yield here in that a quarter right now. I just think that the tailwinds just given the spread that I do believe that rates are going to remain higher for much longer. The fact how far out these maturities are in the debt, a lot of these companies, especially on the large cap side, are just going to be clipping money for quite some time.

John Luke:
They’re banks at this point.

Dave:
Oh yeah.

John Luke:
Right. Borrow low and lend high.

Dave:
I would love to try to figure out the interest. Sorry, John Luke, go ahead.

John Luke:
Yeah, it’s something that I think will drive earnings more than most folks realize is that these companies have so much interest income that they’re receiving in a positive sense that it can insulate a lot of volatility in the economy.

Dave:
Even if you look like Morgan Stanley’s Mike Wilson, this was a big thing that he was hitting against for quite some time, was that leverage is going to start hurting these companies substantially and that’s going to decrease margin, which should decrease the absolute valuation of the company and the market as a whole. We just haven’t seen that whatsoever. That was actually put out in [inaudible 00:11:48] that I did one or two weeks ago. The fact that the interest that’s coming in is substantially higher than the interest expense going out.

John Luke:
Yeah. It goes back to that last chart with NASDAQ valuations with the companies that are making up the bulk of the NASDAQ or the ones that have a lot of this debt after 2030. I think it doesn’t necessarily rationalize the multiples, but it makes them a little bit more tolerable when you put it in that context.

Derek:
Yeah. It probably breaks a lot of the textbooks that y’all studied back in the CFA that when you do go into a rising interest rate environment and companies that have short-term debt have to refinance, it hits their margins. I don’t know, it seems like a lot of US corporations milked it pretty good.

John Luke:
Yeah, well, it just gives you flexibility where they’ve got so much time to plan to pay off this debt. Now obviously the carry cost is low, but they’re going to be paying it off with massively inflated dollars and they’re going to have a whole lot of time to plan on how to extinguish it.

Dave:
I think that’s actually a huge positive for active stock pickers too, because exactly what you said there, D. Hern, what has history told you? It’s like I leverage on balance sheets, it’s binary, it’s bad. You want lower absolute leverage on your balances. Well, now you have to think about it from a qualitative aspect. What do these management teams do to look through that windshield of where they believe that rates are going to be moving forward to position their balance sheet for as much operating leverage as possible? That’s not something that could be computed by some type of computer or some type of tilted factor exposure through a passive smart beta type of ETF.

John Luke:
Yep. The last comment I’d make is the personal finance balance sheet of consumers is about in the same position as this. They’ve locked in a lot of long-term expenses with their mortgage payments being low and they’ve got pay increases and wage inflation that’s benefiting them and giving them more money to spend into the economy today. That’s what you’ve seen the last really year where everyone’s been so gung-ho that the recession was imminent and they just didn’t bake in the benefit of locked in low interest rates for the terms that we have in place right now. Obviously someone owns all of this debt, but it’s less sensitive because it’s locked up to banks and Fed balance sheets and things like that.

Dave:
I wouldn’t say that on the consumer side versus the corporate side that they’re on the same exact level. I think a lot of the data that we saw come out earlier this week on consumer spending, they continued to do, I forget who coined this term, it’s like YOLO spending this summer. I mean, it’s brought down their savings rate to three and a half percent right now. That’s substantially below long-term average savings rates. They are really dipping into their balance sheet, their war chest of capital a lot more I think than what corporations are. When you take that information and move it towards, what does that mean for the market?

Well, the S&P 500 tends to be more of a goods oriented type of exposure while GDP tends to be more heavily on the services side and the consumer side because two-thirds of GDP is made up of the consumer itself. That shows that you could continue to see some type of strength at the S&P 500 levels just because all those corporations tend to be more goods focused. That could be a pretty good investment of just owning some type of cheap beta in the S&P 500.

Derek:
Let’s talk about who did not take advantage of the low interest rates.

John Luke:
[inaudible 00:15:27] hundred year debt offerings?

Derek:
A huge missed opportunity it seems.

John Luke:
Yeah. I know that we looked at issuing some 50 and hundred year paper back at record lows and decided against it. Yeah, it’s certainly concerning in terms of where the Fed’s debt maturity profile is right now. Then also if you think about where they’ve been doing a huge bulk of the issuance lately has been at the front end of the curve, and that’s obviously been to protect the liquidity profile of markets. If you issue at the front end of the curve, that’s the least market impactful as far as draining liquidity from markets. It’s also the most expensive.

As governments and specifically the US government continues to refinance this debt from the low 2% level that we started at when we came into this rising interest rate mess to five and a half percent type of short end rates, it’s definitely having an impact on the fiscal situation of the US. Right now we’re running roughly a 9% deficit, and that’s with 3.8% unemployment. You’re running basically crisis or war level deficits with a “really healthy, strong economy”.

Dave:
I think one of the [inaudible 00:16:50] that when I look at this chart, John Luke, is there still going to be an arm’s length distance between the Fed and the government as all, or is the US government going to try to strong arm the Fed to decrease rates here? That’s why they’re obviously issuing the front end of the curve so they can reinvest once those roll off at lower rates because the government doesn’t think that rates can stay this higher for longer. All the data, I think to all the listeners who continue to listen to us, however far we are in here, all the data that John Luke and I always talk about is that rates should be higher for much, much longer. Is the government going to pressure Jerome Powell and the Fed, even though they’re not supposed to, into jawboning them into actually cutting rates sooner than expected so they can get this interest expense rate down, especially heading into an election year right now?

John Luke:
Yeah, I think that there’s certain ways that they can be a little bit more sneaky about it, like raising capital requirements for banks and doing other subtle forms of yield curve control where they hopefully keep rates to something sustainable. Ultimately, I think that unless the Fed is back involved in buying a lot of this issuance that they’re going to have to keep rates high in order to keep the demand there.

Dave:
If you think what happened back in March, I think everyone only thinks that the Fed, and maybe the US government thinks this too, they only have one lever to pull and that’s to decrease interest rates. That’s not the case. Look what happened back in March when all this banking crisis started to go on the Fed increased their balance sheet, they didn’t cut rates whatsoever. I think if you do see some type of crisis in the near future, I think the Fed is going to utilize a lever that they haven’t historically been able to do, and that’s to increase the size of the balance sheet without cutting some type of rates too. That definitely doesn’t help the US government whatsoever if something does happen.

John Luke:
Yeah, Fed’s balance sheets just creeped below 8 trillion, was a little over 9 trillion to start, so it’s certainly declining. The first trillion roll off of the balance sheet has been fairly smooth, but it’s going to be tough to see them really shred this thing down. If you look back at the FMC minute meetings from the last meeting, they’re pretty imminent that the balance sheet needs to continue to shrink. They’re certainly trying to go down that avenue. It’s just a question of will they be able to, and I guess last point is when you’re running a 9% deficit, that has to get funded somehow, and that means more debt issuance and someone’s got to buy all of it. I think that’s really what you’ve seen the last couple of weeks where rates have shot up higher.

Dave:
Correct me if I’m wrong with this number, John Luke, I’m probably just throwing out a random number. Every $100 billion worth of balance sheet reduction equates to 10 basis points or 20 basis points of interest rate hikes in a way, just from what it’s doing from a tightening perspective.

John Luke:
Yeah, that’s roughly the number that’s quoted. Just not sure the effectiveness because it’s the saying whenever you overuse one of the components of your tool that it dilutes the impact of it. I think we’ve probably seen some dilution.

Derek:
All right, I’m going to hop on one more chart, which has really been the story of this year in particular. Everyone talks about the market being expensive and maybe there’s a ceiling if we’re at 20 times earnings on the S&P index, but especially Dave as you know from studying individual stocks at all capitalizations, there’s a pretty wide range of where things sit. I thought we’ve seen this in a couple of different forms, but I thought this might be a good one for you to go through a little bit.

Dave:
Yeah, it felt like this year has just been a stock market, not a market of stocks. With that latter comment there, a market of stocks underneath the hood of whether it’s the S&P 500, Russell 2000, Russell 2000 value, our entire equity team is still finding opportunities and stuff that we think that there is value out there. Yes, 20 times future earnings on the S&P 500 does seem expensive. If you look at this chart here, it’s showing that the S&P 500, or basically the magnificent seven are trading at 32 point times [inaudible 00:21:16] forward earnings, but if you look at the average stock itself, it’s trading closer to 16.8 times.

That’s a lot more palatable in my mind. That’s why I think we’ve talked a lot about having more of an exposure to an equal weight S&P 500 over a market cap weight, or at least the introduction of some type of tilt to the average stock is pretty important right now. We’re finding a lot of opportunities out there on the individual stock basis and that gives me a lot of optimism I think for the equity markets into the future, even though we’re looking at the S&P 500 trading at 20 times. Like I said, it’s really a market of stocks instead of a stock market probably moving forward.

Derek:
Makes sense. I think a lot of what we’ve seen out of this is people have pinned their hopes on lower valuations. It’s almost, you could also put in the chart on the US versus Europe and versus the rest of the globe. The US has been at a premium multiple for years and people have been burned trying to buy those lower valuation international stocks. You wonder at some point if they’ve just given up and does that set up opportunity. I guess that’s where we sit now. Everyone certainly knows the story.

John Luke:
No, I think that some of these small caps and smaller market capitalization companies where they’re getting exposure to some of this infrastructure spending that’s in place and the re-shoring where maybe that’s being overlooked at the allocation level or where people are allocating dollars because as we move industry back to the US, we re-shore things. We have manufacturing and stuff that’s coming from China, not coming from China, but coming from the US or coming from Mexico, that these companies are going to have to be highly invested in in terms of actually making that happen. I think that is sort of a green shoot for small caps and I’m sure Dave agrees with that.

Dave:
A hundred percent. Here’s where my mind is. My biggest worry for the [inaudible 00:23:26], and I don’t want to open up a whole new can of worms here because we’re probably pressing up on time restraints right now, but it’s exactly what you’ve mentioned there, John Luke, that there is a lot of re-shoring going on in the United States, but it’s very concentrated to a very few [inaudible 00:23:40] state. It’s Tennessee, Ohio, Michigan, Indiana, Texas. You’re not going along the coastlines by any means. When we just spoke about the Fed and a lot of its monetary policy that they’re working on right now in this inflation environment, Fed policy is monolithic. The change that they make at the monetary level, whether it’s on interest rates or whatever they’re trying to pack from a labor situation, it’s broad based across the entire United States.

When I think that re-shoring aspect that we’re talking about here that will benefit small caps, it’s very centralized in a few areas. I think that there’s going to be a pretty big divergence in our country five, ten years from now that not everything is created equal. There’s going to be a disparity amongst geographical regions in the United States where Fed policy may not be as effective as they exactly want it to be because it’s only really affecting a small part of the company as a whole.

John Luke:
Yep. Great point.

Derek:
Awesome. All right, well as everyone knows, there’s a lot of gray, the markets are not as black and white as our services might be, so I’m going to give a plug for some of the work you guys do behind the scenes. Well, you guys and the rest of the CFAs. I think one thing that we’re really, really good at is helping advisors grow, helping them compete for and win and transition and manage high net worth accounts in particular, you guys have both been instrumental in helping someone who’s got a big individual bond portfolio or they bring over an SMA that’s got 200 stocks in it. That stuff’s a pain in the butt for an advisor to figure out from a tax standpoint and just the logistics of, “Okay, great, I can win this $3 million account, but what am I going to do with it? How am I ever going to get it into my models?”

I think I’m going to give a plug, less of a three pointer more of a slam dunk, I’m going to give a plug to if anyone has any of those accounts they’re trying to get or wants to learn more about how we can help with that stuff. I don’t know, I volunteer you guys all the time to help with that stuff and thankfully you take us up on it.

John Luke:
Yeah, thanks D. Hern. Great point.

Derek:
Well that’s good. I think we probably weren’t quite as quick as I would like, but that’s because you guys have good ideas and lots to talk about. It’s good though. I think we’ll do this every month and I would invite advisors to chime in and throw any questions our way that you might want to have discussed. I’ll thank you guys and hope y’all have a great weekend.

John Luke:
Thanks guys.

Dave:
Good day.

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