Collateral Damage: Time to Buy?

Join Chris Perras for the 2/26/2021 edition of Stock Talk!

Chris Perras: Hey, good morning. I’m Chris Perras, a chief investment officer of Oak Harvest Financial Group here in Houston, Texas. Welcome to our February 26th weekly Stock talk podcast: keeping you connected to your money. We took last week off unexpectedly due to the Texas winter storm causing widespread power outages throughout our great state. I hope that everyone has got their houses turned around and is getting back to normal after that event. Was not a lot of fun. I almost titled this week’s podcast February made me shiver after the line in Don McLean’s classic, The Day the Music Died.

However, this week I offer up more detail and my thoughts on what happened this week and the title is Collateral Damage, higher long-term interest rates, inflation, real growth, and the opportunity it’s creating. The TV networks have been littered this week with the topic of higher long-term interest rates and more specifically the concern over higher inflation. It’s the new hot macro topic du jour on the financial news channels. As long-term interest rates have steadily risen over the last nine months, at the same time, most asset prices, including commodities have accelerated higher. That includes copper, lumber, even oil.

I love this topic. I’ve said that the last three weeks. Why? Because it doesn’t take guessing at its answer. This cycle has the answer in it. Clients can log on to our web portal and see a brief presentation I put together on this topic. I’ve discussed a lot of these charts the last three years at Oak Harvest. Interest rates have two components. There’s the expected inflation component, and there is the expected real growth component. When you add them together, you get the actual yield you see on a treasury bond you’re looking at. As of yesterday, the 10-year Treasury bond was about 1.52%.

The inflation component was 2.14% and the real growth component was actually a -0.62%. To me, what’s most interesting the last two weeks is what happened to these two components as the overall 10-year treasury rate has risen. The inflation component, which everyone is talking about on TV, well, that peaked almost two weeks ago, and we pointed this out each and every week and it’s falling while the real growth component is accelerating higher.

One looks at the inflation chart on our web portal. One can see the inflation expectations rose about 63 basis points since mid of last October, much the exact same height and duration in the move of inflation in the fourth quarter of 2012 into early 2013, which coincided exactly with the launch of QE2 by the federal reserve in September of 2012 and president Obama’s second term. Back then, inflation rose 64 basis points. Fast forward to the fourth quarter of 2016 and Donald Trump being elected, and yes, listeners, inflation expectations rose 63 basis points over the exact same timeframe.

I note all this once again to remind listeners, these moves are not unprecedented. We have seen them before, just this cycle. What to draw out from the charts now, inflation worries should be peaking, if not, should have already peaked for the first half of 2021. Meanwhile, real growth is now picking up, which is what equities in our economy long for. Once those factories and the economy start returning to 80 to 100% capacity utilization, supply starts to catch up with demand and prices tend to peak, manufacturers spend money on CapEx to add capacity, to meet demand, which is a boon for the economy and tends to dampen future inflation expectations.

What happens as the economy reopens, the velocity of transactions in the real economy picks up, people go out and eat more, people go out and get more medical device implants, they travel more, they buy more discretionary items to fill their newly purchased homes. In a nutshell, there’s a handoff from inflationary growth in the economy to real growth. In our web portal, clients can view the PowerPoint presentation and see how similar the pattern is in long-term rates and its two components, inflation, and real interest rates to the second half of 2012 and 2013.

That was the second Obama administration and the S&P 500 rose 32 1/2% during 2013 as the 10-year interest rate did what? It doubled from 1 1/2% to 3% and real growth accelerated. The world didn’t collapse. The financial markets didn’t collapse. Listeners, think about it, from mid last year, 2020 around July 4th, though last week’s high on the S&P 500, the 10-year interest rate rose about 100 basis points. It rose from about 50 basis points to 1 1/2%.

It rose about 1% and what did the S&P 500 do? It rose from roughly 3,250 on July 4th to a closing high of 3,935 on February 12th. That’s a rise of over 20% while interest rates went up. What is particularly of note is that during this entire time period, the rise in interest rates was almost 100% inflation. We now sit at the end of February 2021, and guess what component of interest rates peaked two weeks ago? Yes, the inflation component. Guess what components started to turn up about two weeks ago? The real growth component.

What did happen back earlier this cycle is that as this happens at first, we experienced about or two of short-term volatility in the equity markets, which is caused by forced de-levering by hedge funds. I’ve called this collateral damage in the past. Recall, our past discussions around collateral damage that tends to flow over to the stock market for a few days or weeks when hedge fund collateral like treasuries or mortgage bonds start to become too volatile on their own right.

These investors and traders are forced to sell assets regardless of price and regardless of whether they like to or not. That’s what happened yesterday. You could see it. The market went straight down all day. People don’t want to sell that. They’re being forced to sell that. They sell good companies along with bad companies, they sell bonds, they sell gold, they sell commodities, they sell small caps, large caps. They sell whatever they can because they’re being forced to by their prime broker. They sell the liquid stocks along with the illiquid because they’re being forced to.

Of the last 16 rising rate environments, the market has rallied 13 times. So rising rates are simply reflecting the fact the economy is recovering, vaccinations are working. Before closing, I want to address an asset class we get calls on quite often. That is one of buying and owning gold as a hedge against inflation. The PowerPoint presentation includes a chart at the very end on the gold commodity. The net results our clients can see, viewers, is that since the market’s closing lows in March of 2009, gold has doubled.

Well, that sounds good. That’s up two times. That might feel good. It represents about a 6% annual return had you bought it perfectly and unfortunately, it’s provided you zero income along the way. During that time period, the S&P 500 has gained over 400% during the same time period. That is over four times the return of gold while also providing some dividend income along the way. During that time period, the big winner since the market lows, the growth-oriented NASDAQ, which while providing some, but very little dividend income, has gained over 900% or 10 times your money during the past 12 years.

Gold provides no income. It is shiny and pretty as jewelry and earlier in its life, much earlier, before paper money, and now digital transactions, it was a medium of exchange for buying and selling goods. Now, well, relative to governments printing money, it is a store of value. However, it is not an inflation hedge. If you want in an inflation hedge, you need an asset that grows with or faster than the economy, that produces increasing income or can raise its pricing over time, such as equities or real estate, historically.

Equities and their compounding over time through the transfer of the economy to the equities income statement is the best inflation hedge for investors, in my opinion. The data hasn’t changed. As the year progresses, the economic clouds should continue to clear and volatility should actually decline to lower levels. Where are we now? We’re in a bull market. We have been since April of 2020.

It’s one that re-accelerated on cue on October 28th, 30th, in 2020 in front of the presidential election. We hit the normal first quarter air pocket on higher interest rate worries. We believe this to pass over the next few weeks. Today, the house of representatives is set to vote and pass the 1.9 trillion, with a T, American rescue plan. This is the sixth COVID relief package, which will provide about $400 per week of unemployment insurance benefits until late August of this year. It’ll provide $1,400 rebate checks to most individuals on the back of the $600 payments that were granted about two months ago.

It will provide more aid and vaccination distribution, schools, childcare, hard-hit industries, and municipal governments. The most contentious proposal, the one to double the federal minimum wage to $15 an hour over the next four years looks like it’s going to be scrapped for now. All these things are good for the economy and for stocks over the next three months and throughout most of 2021. The collateral damage caused this week by the rapidity of the recent rise in interest rates has caused leveraged players to sell and to likely miss out on the positive effects of these stimulus programs.

Much as they were forced to sell in front of the election, and then they had to turn around and scramble back into stocks and keep buying them in December and January at higher levels, this too could play out like that in March in the second quarter. At Oak Harvest, we are comprehensive long-term financial planners. What this means is that as our client, you and your financial advisor should have a financial plan that is independent of the volatility of stock markets. Give us a call at 281-822-1350. We are here to help you on your financial journey with a customized retirement planning. Have a great weekend. This is Chris Perras. God bless you, your family, and stay safe.

Speaker 2: All content contained within the Oak Harvest podcast expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created, but any cited data, indicators, statistics, or other sources are not guaranteed. The views and opinions expressed herein may change without notice. Strategies and ideas discussed may not be right for you and nothing in this podcast should be considered as personalized investment, tax or legal advice, or an offer or solicitation to buy or sell securities.

Indexes such as the S&P 500 are not available for direct investment and your investment results may differ when compared to an index. Specific portfolio actions or strategies discussed will not apply to all client portfolios. Investing involves the risk of loss and past performance is not indicative of future results.