Rebecca Hotsko (00:03:09):

After I connected with you a couple weeks ago now, I started reading all of your weekly newsletters. It just got me thinking about some great topics to talk to you about, and I really want to cover the valuation tools that are used to assess whether the market is overvalued or undervalued because I think they can often be misinterpreted by a lot of beginner investor’s, and so, I wanted to go over with you today how to interpret them, what they’re telling us about the market today, and just kind of what we can expect going forward. But I guess before we jump into all of that, for our listeners who don’t know you yet, can you talk a little bit about what you do?

Lance Roberts (00:03:48):

Sure. I didn’t come up through the financial ranks like most people in the industry. I actually started out in banking. A long time ago, back in 1987 was my first job at a bank. I actually started working for a bank three days before the ’87 market crash, and I was managing a book of treasuries for CD deposits at the time, and of course, going through 1987 crash, and then I moved from there into doing private management for high-net-worth individuals overseas, and I spent quite a few years living in Europe, working at different banks and doing different activities for high-net-worth investors.

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Came back to the United States in the late ’90s, opened up a broker dealer, and then saw what was coming in the 2000 kind of dot-com crash. Again, probably before a lot of your listeners remember this, but prior to the dot-com crash, we were having a lot of these crazy things going on in the markets. We had people day trading stocks. I mean, firms were opening up entire floors of companies to day trade stocks, and that was the thing, of course, e-trade was just getting launched. Online trading was a new thing, and all of a sudden, Wall Street became very mainstream and retail investors thought they had the tiger by the tail, and course it didn’t end well because we were way overpaying for things that had no value, had no revenues, had no real game plan going forward. We had Enron and was kind of the poster boy for that period, but a lot of these dot-com companies just completely crashed and went away, and we learned a lot of lessons from that.

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But at that time, when I saw it coming, sold the broker dealer, opened up and registered an investment advisory firm at that point, grew that firm to about $700 million, sold it, and then joined the firm I’m with now back in 2016, and we now currently manage a little over $1.2 billion, and we are primarily focused on providing individuals with risk-managed portfolios, and again, this is what I did for high-net-worth investors. This is something I don’t see offered very much kind of in the world today. It’s a lot of you just buy and hold and ride the markets up, it’s fine over time, but when individuals have money, and this was always the very interesting thing with the clients I worked with, they were like, “I don’t really care about making money, just don’t lose what I’ve made.” The focus is always more on risk, and if we can control risk over time, we’ll actually wind up performing a lot better.

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We were just talking about this morning on our radio show about the thing that investors do that lead to more mistakes than anything else, and this is driven by Wall Street. Wall Street has taught everybody to measure their portfolio from the beginning of the year. How are you doing this year? Well, you’re down this year. Well, that’s okay, right? That’s part of investing, and understanding that markets do decline is very important, but Wall Street wants you to focus on that decline. They want you to make these decisions to move money because moving money creates fees for Wall Street. It doesn’t necessarily do anything good for you.

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When you look at your portfolio, the first thing you should do is look at it over a longer period. Look at over a two-year period or three-year period. Now all of a sudden say, “Yeah, I’m down here, but I started here, I was at a $100,000 three years ago. I’m $140,000 today. I was 160, I was up higher this year, but I’m still ahead. I’m still on track to meet my financial goals.” The reason I bring that up, and this is going to get into the whole valuation argument because it’s all about psychology, is that we need to make less emotional decisions, and so, if we start looking at things from a more realistic perspective about where we’re trying to get to with our investing goals, we’ll make better investing decisions over time.

Rebecca Hotsko (00:07:26):

I love that. I just have a quick question on that. Instead of maybe looking at a year over year return on our portfolio, you mentioned looking longer term. Do you have a preferred metric or return metric that you use, maybe a money weighted one or something like that?

Lance Roberts (00:07:41):

We look at time-weighted returns. We look at them over a two-year period, and again, so you think about this, right? And everybody’s talking about the Federal Reserve at the moment, and the Federal Reserve is like, “Oh my gosh, when’s the Fed going to pivot? When are they going to go back to doing QE and cut interest rates?” Well, when the Fed looks at the markets, what they’re focused on, the reason the Fed started doing QE in 2010, Ben Bernanke came out and said, “Hey, we’re doing quantitative easing in order to boost asset prices because that will boost consumer confidence,” and what this was termed is the wealth effect. And so, the way the Fed looks at the market, the Fed looks at the market, they don’t see the market down 20% this year. They’re very aware of that, but they look at it from the function of where were we in 2019, 2020 at the peak of the market before the market downturn there, where are we today, and see, we’re still up like 20% from those March 2020 peaks.

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For the Fed, the wealth effect is still there, and for investors, even with the decline, they’re still at a higher level than they were just two years ago, and the annual rates of return are still running 7, 8, 9%. If you’ve been doing a good job managing your money, you’re still on track. If your goal is to make 10% a year or 6% a year or whatever it is, you’re still on track for that goal, even with the decline this year. Stepping that timeframe back, getting a little bigger picture about what you’re doing with your money will give you a much better decision now. If you look back over that two-year period and it’s terrible, well, then you realizing you’re making too many mistakes, particularly in a bull market, right? And so, this is where maybe you need to reassess your strategy. It’s not working the way it should be.

Rebecca Hotsko (00:09:17):

I think that’s really great. Jumping into kind of these common valuation metrics that are sometimes used by investors to assess where the total stock market is and if it’s overvalued or undervalued, I think one of the most common ones is the Shiller CAPE Ratio. Can you talk a little bit about what this one is, how to interpret it, and where it is telling us that the market is today?

Lance Roberts (00:09:45):

Sure. Before we get into the specifics of the CAPE ratio, let’s just talk about valuations in general and what they are, right? What valuations are is, and there’s lots of different measures of valuations, so there’s PEs which are price to earnings, there’s price to sales, there’s price to book value, and these are all just different accounting measures. It just depends on what you want to look at in terms of how you measure the value of a company.

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The reason valuations are important, Rebecca, let’s say that you have a podcast company and you’ve decided you are ready to capitalize on your business and you want to sell your podcast company. I think it’s a great idea. The first thing, now this is a private transaction, so we’re not public, we’re not in the markets, it’s just you and me sitting across the table. And so, I’m going to say, “Well, look, tell me what your revenues are, tell me what your expenses are, tell me what your net profit is,” right? And you’re going to tell me that you make a hundred million a year doing a podcast and you’ve got expenses of 50 million a year because you like Gucci bags and your net profit’s $50 million.

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When I know what that is, I can now come back to you and say, “Okay, well, you’re not going to sell your business to me today for exactly what you’re making one year from now.” You just keep your business for a year and make $50 million. That’s easy math. I’ve got to pay you a premium for that. This is where we’re going to look at that value and say, “Well, I’m going to pay you three times your value today because I’m going to own your business for the next 10 years, so I’m going to give you three times your rate of income,” and that’s the value. See, we’ve now attached a value to that business.

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Well, in the financial markets, when we buy a stock, that’s what we’re technically doing. And so, when we look at a company like NVIDIA or AMD or Microsoft or Google, whatever company you like, we start to just forget that we’re buying the piece of an actual business, and we just start paying whatever value there is asked in the markets because we just hope that the price of the stock is going up, and we’re not actually making a value-based investment. We’re just buying a piece of paper hoping it’ll go up higher on price, and this is the very definition of what we call a greater fool theory. We’re always just hoping there’s a greater fool than I that will buy my stock from me at a higher price down the road. This always inevitably ends badly.

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When we overpay for something, eventually that value is going to revert back to its fair value, whatever that is. If we overpaid for it, we’re going to make less on it in the future at some point. Now, we may get lucky and sell early, but this is in theory, if we’re buying Apple, we’re going to hold it for 10 years, as an example, if we pay 15 years of value today, in 10 years, that price is going to come back down to what 10 years of value is. So, we’re going to wind up losing money. It’s very simply think about a house in a neighborhood. Every house in a neighborhood is $250,000, but you pay $500,000 for a house in that neighborhood. Well, when you go to sell your house, you’re going to match it to the comps and the other houses, you’re going to lose money, right? It’s the same thing in the market.

[NEW_PARAGRAPH]That’s what valuations are, and there’s many ways to measure valuation. There’s no one set way. Everybody does valuations a little differently. You can do dividend growth, you can do market cap to economic growth. I mean, just massive amounts of different valuations, but they all tell you the same thing. At the end of the day, what valuations tell you is how much are you paying today for a dollar’s worth of earnings tomorrow, five years from now, or 10 years from now.

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Now, let’s go back to your question about CAPE, right? Dr. Robert Shiller came up with a valuation method called the CAPE. It’s the cyclically adjusted price earnings ratio. It’s the price of stocks divided by 10 years of earnings. Now, why did he pick 10 years? I don’t know why he picked 10 years. He just did. I’ve modified that analysis to use five years’ worth of earnings which gives you a little bit more sensitivity to the markets. But what it does is it strips out these very volatile years of earnings. A good example is 2020, right? In 2020, we shut down the economy and earnings collapse because there was no business, right? We had the pandemic. We shut down the economy. Companies had no business going on temporarily because everything was closed.

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What the Shiller CAPE does is by using 10 years of earnings, it takes these anomalous years of an earnings spike or an earnings decline and smooth that out so you get a little bit better picture about what the mean valuation is or the trending valuation is over time. Historically, if you’re paying more than 23 times earnings, so going back to 1900, every time the market got to 23 times trailing 10 years earnings, that was the peak evaluation in the market. Now, what does that mean? What does 23 times earnings mean? What does 15 times… We throw these out all the time. The media is terrible about this. They go, “Well, based on forward earnings…” When you look at forward operating earnings, take that, throw it out the window because that is all a wild guess and it strips out everything that happens with a company’s earnings over time.

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What I mean by that is that what forward earnings look at, these are called proforma earnings, and this is assuming everything works just spectacularly. There’s no pandemic. There’s no economic downturn. There’s no spike in interest rates. I have the same amount of sales that I’m counting on. I don’t have a slow down in sales for any reason. It’s this perfection-based idea that never actually occurs. If you’re ever buying a stock based on forward earnings, you’re almost guaranteed that you’re overpaying for the stock today. Always look at trailing in the pocket what the company actually made. You’ll do a lot better over time.

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Now, so what does this mean? If I go out today and I pay 22 times earnings for a company, what that means is that if the company pays me my pro rata share of earnings every year, they pay it directly to me, they send me a check, a company earns a dollar, I own a hundred percent of the shares of the company, just in this example, they’re going to send me a dollar’s worth of earnings every year. Now, if I paid $22 for that dollar’s worth of annual earnings, that means in 22 years, I’ll get my money back. That’s what that means. When you overpay 22, 23, 25, 28 times earnings like you’re doing today, you’re guaranteeing yourself a lower rate of return over a long holding period because the company can’t earn earnings and distribute those earnings to you at that rate over a long period of time, and you’re probably not willing to hold stocks for 28 years to break even.

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But that’s what valuations tell you, and there’s a very high correlation between what you pay today and what the market return is over the next 10 years, and those are heavily inverted. In other words, if you’re paying 28 times earnings today, your return out of stocks over the next 10 years is likely to be close to zero. That’s what the Shiller CAPE Ratio is and that’s what it tells you.

Rebecca Hotsko (00:17:00):

I love that you went into detail about just on the individual stock level because I was going to keep this on a total stock market valuation level, but I think that was so helpful, and I think we could have an entire discussion just talking about those valuations too and going back to the basics of what those mean you just described because I think for a while, there’s been so many companies that investors want to buy the Googles, the Amazons that just have such high PE ratios, and sometimes they’re justified, but I think we kind of forget what that actually means and why it means, like you said, it’s just lower expected returns in some cases. Keeping it on I guess that total stock market level on the Shiller CAPE, so right now, it is at a very overvalued level relative to history. And so, I guess can you talk about what this means and maybe what it doesn’t mean?

Lance Roberts (00:17:55):

Sure. Here’s the problem with valuations as a function of individual investors, and I see this happen all the time on the financial media and when I do interviews with people, they go, “Well, what do you think about valuations currently?” Valuations are the world’s worst market timing devices. You should never buy a stock or an index or an ETF or a mutual fund or anything based on current valuations and assume that, hey, I’m going to buy a short S&P 500 index because valuations are at 28 times earnings and that means that prices are going to fall. That may be the case, but they’re terrible market timing tools, and what happens is with a lot of people is they buy these things based on valuation and then it doesn’t work out immediately, right? There’s not an immediate gratification of that decision, and so, they bail out of that and they go wind up buying more overvalued assets, and then they wind up getting hurt because eventually that valuation metric matters. So, never use valuations as a market timing tool.

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What valuations tell you with absolute clarity is what your forward returns are going to be on markets over a longer term timeframe. Now, this is also tricky because you got to be careful with this. Now, if I tell you today, and this is the assumption that people make, I’m going to tell you a fact is that going back to 1900, every time valuations or over 25 times earnings on the Shiller CAPE, forward returns over the next 10 years have been zero to negative. Now, you go immediately, it’s like, “Well, I’m just going to get out of the market because every year is going to be zero to negative returns over the next 10 years.” That is not what that means.

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What that means is, is that over the next 10 years, you are going to have some excellent market rallies that may last a year or two or three, and markets may be up 10, 15% over those two or three-year periods, and then you’re going to have a couple of years where the markets are down 10, 15, 20%, and then you’re going to have another couple of years of a rally, another couple of years of decline. At the end of it all, when you go back and look at your returns over the last 10-year period, you’re going to go, “Geez, my return was near zero.”

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Now, has that ever happened in history before or am I just making that up? Well, all we have to do is go back and look at the markets in 1999, 2000. In 1999, 2000, the market was trading at 42 times earnings. In 2013, based on total return inflation adjusted markets, the market broke even to where it was in 2000. 13 years of no returns, but in there you had a bear market, a massive bull market, another bear market, and another bull market rally. You had these two big bull markets and two big bear markets right in the middle of this whole 13-year period where you made no money on a holding basis. Now, if you were trading stocks, that’s different, but if you were buying and holding the market over that period, you made no money.

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Did it ever happen before that? Well, 1960s to 1970s, you spent almost 20 years making a 10% negative after inflation rate adjusted return in the markets. When did it happen before that? 1929 to 1952, you made no money in the markets for almost a 20-year period. Why? Because starting valuations were over 20 times earnings, and those valuations had to mean adjust over time for inflation, for valuations, for economic growth, all these type of things. What valuations tell you, and a big one is, and I guess we’ll talk about this one, is market caps GDP, the Buffett indicator, but that’s what valuations tell you. It doesn’t mean every year’s going to be zero. It means your long-term holding period will be close to zero, and there’ll be a lot of turmoil in between. Great trading opportunities, terrible holding opportunities.

Rebecca Hotsko (00:21:46):

Yeah. I checked this morning and it says the current Shiller PE Ratio is about 20 right now, and then the mean is around 17. That would suggest a quite significant mean reversion if that’s to happen. But I wanted to share this with you today and get your thoughts on this because a while back I actually read a really good paper. It was a 2017 paper titled Market Timing: Sin A Little Resolving the Valuation Timing Puzzle. And so, these authors constructed a market timing model using the Shiller CAPE, and so, they sold equities when it was really high, when it indicated that equities were overvalued and bought equities when the Shiller CAPE Ratio was low, and they found that this portfolio actually underperformed over 57 years, and it was because the markets kept going more, stocks kept getting pricier, even when the Shiller CAPE indicated it was overvalued.

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It just kind of made me think of today’s market that things can keep becoming more expensive for longer than we might expect, and so, I thought it was just super interesting and relevant to today because we might see it this Shiller CAPE Ratio very high today. Yes, it looks overvalued relative to history, but it could still remain there for longer. I guess I’m just wondering what kind of catalyst do you think would cause the overall market to start to mean revert to a more historically normal level?

Lance Roberts (00:23:10):

Well, I think we may be in the midst of that at the moment. Two things are going to happen here now. First of all, we’ve got the Federal Reserve now combating this inflation fight, right? They’re hiking rates and they’re reducing, they’re doing what’s called quantitative tightening, and so, they are reducing their balance sheet. During the monetary interventions from 2009 until 2022, they were buying bonds to help increase liquidity to markets and raise asset prices. Now, they’re reversing that process at a rate faster than any other period in history. They’re extracting liquidity both by letting bonds mature on their balance sheet and raising interest rates which makes cost of borrowing more expensive and adjust the valuations of market.

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What could cause the market to mean revert, right? That’s the question. Market mean reversions are all psychological. It’s basically at some point that investors go, “I’m out,” and they’re all out at one time, and we start to see big liquidations across markets and we’ve seen some of that this year. Markets are down, as we’re talking today, roughly 22%-ish for the year. We’ve kind of gone through a bit of this work in terms of reverting these valuations. But there’s an interesting conundrum that’s going to be coming up here because again, let’s take a look at PE. What is PE comprised of? It’s price of the market times the earnings of the companies in the market. In this case, let’s just talk about the S&P. Let’s assume for a moment that the price of the market doesn’t go down or up for the rest of the year and actually doesn’t go down or up until we get to the end of 2023. Well, the problem is, is that between estimates for earnings for the S&P 500 are still way too elevated.

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If you take a look at the long-term history of the markets, earnings grow from peak. If earnings grow to a peak and then they decline, if we measure that from peak to peak, that’s about a 6% growth rate over time going all the way back to 1900. That peak-to-peak growth rate of earnings is about 6%. Right now, estimates are estimating that stocks will outgrow that long-term trend by a large percentage. In other words, expectations for earnings are much higher than what the economy can actually generate.

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Now, think about this for a moment. Where do earnings come from, right? They don’t just magically appear at the bottom of an income statement, right? They have to come from somewhere. They come from sales which is what happens at the top of the income statement. This is basic accounting 101. Here we go. At the top of the income statement, that sales or revenue, where do those sales or revenue come from? Well, that comes from you and me, right? We go out, we order stuff from Amazon, we go to Walmart, we go to Target, we do whatever we’re going to do in life, we’re going to buy a car, buy a house, we’re going to furnish our house, that’s what creates sales.

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Economic activity is where sales come from, and therefore by extension, sales cannot outgrow the economy long term because they’re tied together, but there are times where we do things like, oh, send checks to households that allow people to buy more than they would from economic activity because they’ve been granted something. Something’s happened that creates this surge in sales at the top line, and that’s what we saw in 2020, 2021 is a good example. That’s got to come down. Now back to our valuation issue. Looking forward over the next 12 to 24 months, assuming price doesn’t move, these earnings are going to come down. If earnings come down and price doesn’t move, valuations move up. That 28 times earnings in theory will be 30 to 35 times earnings by the time we get to the end of 2023. If prices decline and earnings decline at the same rate, then valuations will stay basically the same.

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Here’s the bad news. In order to get valuations down, earnings are going to come down, but prices have to fall faster. That’s where you get that mean reversion in the markets that gets you down 25, 30, 35, 40% during a recession because what happens during a recession, earnings fall, and as earnings fall, markets have to reprice the shares of companies for lower earnings. That means prices have to fall more than earnings are falling, and that’s where that real risk for a recession due to valuation reversions occurs in the markets, and that’s our big risk going into next year.

Rebecca Hotsko (00:27:35):

I love that you touched on kind of the connection between earnings and the economy and how they grow faster over the long term because the next valuation metric that I wanted to talk to you about was the Buffett indicator which compares the total stock market to GDP. I’m wondering if you can just talk a little bit about do you see why you think this metric is valuable? Warren Buffett was once quoted saying that this is one of the best indicators to kind of show where the market stands, and so, I’m just wondering what your thoughts are in that.

Lance Roberts (00:28:09):

Yeah. There’s a few ways to calculate the Buffett indicator just real quick. You can do it on your own, by the way. There’s a couple different ways that you can value the market using the quote, unquote, “Buffett indicator.” All it is, is market capitalization divided by economic growth or the size of the economy, right? What’s market capitalization? Market capitalization is the total number of shares outstanding for the markets, the S&P, the Wilshire 5000 Index, pick an index. And so, you look up that index and say, “Okay, how many total shares are outstanding and what is the current price of the index?” If I take the total number of shares outstanding, so let’s say that I’ve got 10,000 shares outstanding and the price of the market is a dollar, my market capitalization is $10,000, right? I mean, it’s a pretty easy calculation, but that’s what market capitalization is. I take that number and I divide that by the size of the economy.

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Now, why on earth would I want to do that? Well, we kind of touched on that already. If the economy is where all the economic activity is derived, and that is where the earnings and revenues for companies come from, and again, if we go back historically, the growth of the economy, now I’m going to put a little caveat here real quick, if we go back to 1900 and look at the market from 1900 to 2009, we need to stop there for a moment. What we’ll find is, is that the economy grew at about 6% annualized during that period. Capital appreciation on stocks was about 6% annualized during that period. Now, dividend yields, and I often hear advisors and analysts, they’ll say, “Well, the market gives you 10% over time.” That’s not really true. What they give you is about 6% over time, not accounting for inflation. We have to subtract inflation, but 6% nominal and 4% of that 10% that you got came from dividends.

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Now, it’s an important measure to remember because dividend yields today are less than 2%. If I was going to get a 6% growth rate in the economy today which we’re not, we’re getting 2%, and I was getting 4% out dividends, that’s one thing, but I’m getting a 2% growth rate out of the economy and a 2% dividend yield, so my long term estimated returns going forward is going to be 4%, not including inflation. The point about market capitalization to GDP is if my GDP is $20 trillion and my market cap is $40 trillion, then the market is valued twice as much as the economy, and that can’t be the case because they are one and parcel of the same thing. They are symbiotic relationships between the two. If I’m paying two times as much for the market as what the economy can generate, I’m going to have a problem down the road, and that’s why Warren Buffett says this is really the only indicator that matters.

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Now, right now, that Buffett indicator, depending on how you measure it, runs between one point, and the reason I say how you measure it depends on what index you use, whether you use the S&P, the NASDAQ, the Wilshire 5000, whatever, but that runs between 1.5 and about 1.8 times the value of the economy, so you’re paying almost and we were paying more than two times the economy in 2021. That’s come down here lately, but we’re still way too elevated for what we’re paying for assets versus what the economy can actually generate in earnings, and that’s why when we go back and talk about mean reversions, valuation reversions. Earnings and values have to come down because they can’t stay this detached from the economy long term.

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Now, I said a moment ago, we had to stop at 2009, and the reason we had to stop that analysis at 2009 for this conversation was is because from 2009 to 2022, we had this distorted markets because of the repeated financial interventions in the markets over that last 12-year period, and this is what I mean by that. Going back to 1900, the average rate of return in the market was about 8% on average. That’s good years, bad years, everything, 8% was your growth rate in stocks over that entire timeframe period. Since 2009, because of these interventions and zero interest rates, the average rate on stocks has now grown by four full percentage points to 12% annualized rate of returns. That is unsustainable. Again, returns can’t be greater than the economy.

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So, because of all these artificial interventions, we have distorted both valuations and returns, and unfortunately, we’ve raised an entire generation of investors, you got to remember, most younger investors, their first investing year when they turned 18 to 20 was right after Obama was elected president, right? They’ve never seen a real bear market until now. All they’ve witnessed is, is these Fed-fueled markets that have been distorted in terms of returns and valuations over time. Because of these elevated returns, we’ve lifted the valuation from their long-term means. We’ve distorted that valuation meeting you were just talking about, the average valuation has been lifted. That is unsustainable. That median valuation will have to fall in the future to realign with what the economy can actually generate, and at 30 trillion in debt, that economic growth rate is going to be lower than the long-term growth trend that we had in basically a zero debt economy in the 1950s and ’60s.

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We’ve been eroding economic growth capacity because of debt for the last 40 years. That’s now caught up and that’s why we can’t grow the economy at faster than 2% and this is why we can’t sustain inflation above 2%. This is why the Fed’s so focused on 2% inflation because the economy can’t withstand higher rates of inflation and higher interest rates that would come from higher inflation because of all the debt.

Rebecca Hotsko (00:34:05):

That’s super interesting that you mentioned the connection between GDP and earnings and how earnings can’t grow faster than GDP in the long term. But I’m wondering, what about the short term? How does that relationship hold up?

Lance Roberts (00:34:19):

Earnings can grow faster than GDP coming out of a recession, right? Coming out of 2020 when we shut down the economy, we laid off all these employees and then we gave everybody money. Earnings were exacerbated back to the upside because you had these big profit margin gaps. You had no employees to pay because we laid them all off, but you had this big influx of demand. Earnings can outgrow the economy on a short term basis, and that’s absolutely true, happens all the time, particularly coming out of a recession, but it can’t do it over a long period of time because ultimately earnings are derived from the economy.

Rebecca Hotsko (00:34:53):

Then you mentioned since 2008 because of the Fed policies, we’ve been in this unsustainable place. Where do you see us going forward then if we’re just in this low expected growth rate environment for, how long do you think, the next decade?

Lance Roberts (00:35:10):

They did a survey in the late ’90s, this probably ’98, ’97, ’98, and this was back when there was a lot of, and again, you won’t around for this, but the insanity in the market had gotten to such an extreme here in Texas up in Dallas, they had taped out a grid on the ground. There was this big grid on the ground and they put the tickers of stocks in the grid and they would bring out a longhorn steer and wherever he pooped, you would buy that stock, and that cow had almost a perfect prediction record for buying stocks back in ’98, ’99, right? Just kind of symbolic of kind of the insanity that got into the markets at that point. To answer your question, at that point, nobody predicted a 13-year period of zero rates of return. Jim Cramer in March of 2000, gave out his 10 stocks for the next decade. In two years, eight of 10 of those stocks were bankrupt and the other two had gotten acquired. Nobody can predict that far ahead.

(00:36:12):

They did a survey of the best predictors in the world, and so, they went and they surveyed fortune tellers and meteorologists , a psychologist, I mean, just anybody that made a prediction, they went and surveyed these people and they said, “Okay, make some predictions for me,” and then they measured how accurate their predictions were. Wall Street analysts were included in that list of people, and it turned out that the most accurate predictions were three days into the future, and they were coming from meteorologists which we always blame our weathermen for never telling us it’s going to rain, right? They say, “Oh, it’s going to rain,” you take an umbrella, it never rains. Yes, but meteorologists are the most accurate predictors and they’re accurate for about three days in advance. Everybody else is terrible.

(00:36:54):

To say that in 10 years markets are going to be near zero, I have no idea, and you can’t really buy stocks today and go, “I know for a fact I’m going to make money on this thing 10 years from now.” Too many things can happen. I mean, in 2019, we had no idea what was going on, right? In August of 2019, I wrote an article, I said, “A recessions coming because all these indicators tell us a recession’s coming.” Now, don’t know why a recession’s coming, don’t know what’s going to happen. It’s going to take some exogenous event to trigger the recession, but all these indicators tell us. We had an inverted yield curve, the Fed was bailing out the repo market, The NFIB survey was telling us that we were heading towards recession. February of 2020, we’re selling stocks like crazy because the market is so extended and so deviated from their long-term means that we said, “Hey, we got to take money off their market.” We had no idea about the pandemic and shutting down the economy, but that’s what happened the next month.

(00:37:54):

The problem is, is that you never know what these exogenous events are going to be. What we do know is that over the next 10 years, returns on stocks will most likely, and again, you can never guarantee anything, but most likely are going to be lower, and we’re talking about now indexes, right? There’s always individual companies that’ll do great because they’ve got some new technology, whatever it is, they get bought out, they merge, whatever, and a stock can do something much different than the overall market. But just talking about the overall indexes, if you’re buying and holding an ETF, the expected rate of return over the next 10 years is going to be somewhere between zero and 2%, not accounting for inflation. That’s just what the numbers tell us.

(00:38:32):

Now, what causes that, I don’t know, and I can’t even tell you. I am pretty confident right now, all our economic indicators tell us that we’re probably going to have a recession next year. If that’s the case, earnings are going to come down, and that suggests lower stock prices. There’s no guarantee that’s going to happen because the Fed at any moment now could come out and say, “Hey, we’re done hiking rates, we’re dropping rates back to zero and we’re going to start QE again.” The Bank of England just today, I don’t know if you saw this headline this morning, but just today, this is Wednesday the 28th, right, Bank of England announces that they are stopping QT and they’re going back to QE. Why? Because their pension fund was getting so many margin calls that they were about to have financial instability in their markets.

(00:39:15):

The fight for inflation is all fine and dandy until you have financial instability. A financial instability event like Lehman in 2008 can cause a depression in the economy. That’s the one thing the Fed will not tolerate. They’ll tolerate inflation and they’ll fight inflation as long as everybody’s behaving, but as soon as market instability shows up, that’s going to reverse. We’ve now trained investors for the last 12 years that every time the Fed does QE and drops rates to zero, you buy stocks. Now, there’s a risk that at some point they may do that and investors wake up to the fact that that’s really not good economically and maybe they don’t buy stocks, maybe it doesn’t work in the future, but we won’t know that until we get to that point in time. Again, the point of the thing is this is look, there’s a lot of risk ahead because of valuations, because of the markets, because of what’s happening behind the markets as well, but there’s no guarantee about outcomes, good or bad.

(00:40:10):

That’s why it’s important, as we started out this conversation, is that we understand what we own, we understand the valuations that we’re paying for what we own, and we manage that risk over time, and that means that sometimes we have to sell stuff that we don’t want to necessarily sell, and it means sometimes we have to buy stuff that we really don’t feel like buying, but that’s the thing. Let me give you a good example. Right now, everybody hates bonds, right? Bonds are having the biggest bear market since the 1700s in the long-dated treasury bond market, right? The biggest drawdown in a century. Nobody wants to own long-dated treasuries. I’m telling you right now, if you buy bonds now and put them in your account, in 10 years, not only will you make money on it, but you’re going to have a nice rate of return over time, probably greater than owning stocks over that same period because in bear markets we never want to buy what’s not performing.

(00:41:03):

In late 2020, we were talking about buying oil stocks because nobody wanted to own oil stocks because of climate change, because the oil prices were basically negative, and energy stocks were the anathema of the markets, so we said, “You need to buy energy stocks. These things are deeply undervalued and they’re going to give you a great return.” And those have been the best performing asset class this year in particular during this bear market. They’ve been doing exceptionally well. Buying things that we emotionally don’t want to do is sometimes the best things we can do for our portfolio. Selling the things that we don’t want to sell because we’re convinced they’re going to go the moon is sometimes the best thing we can do for our portfolio. Being a bit of a contrarian investor has historically provided better outcomes than just kind of following the markets.

Rebecca Hotsko (00:41:50):

I want to touch on a couple things there. First, I am curious on the bond aspect. I’m just wondering how do you think that kind of fits into a millennial’s portfolio? I guess everyone at the end of the day just wants to make a return. Would you say that’s a smart move then for a millennial to maybe consider some of that in a portfolio?

Lance Roberts (00:42:09):

Absolutely. Look, you have to understand two things. Look, nobody spends time talking about bonds. Bonds are boring. Watch CNBC all day, they never mention the bond market, right? It’s all about stocks, and this is all about the chase. If I could tell you, you can go to Vegas and have a guaranteed return, you’d probably take me up on that bet, right? Because man, I can go and I can just gamble, I’m going to make money. The problem is, is that stocks don’t give you a guaranteed rate of return. Bonds do. And the important thing to understand about fixed income and the reason that when you look at a high-net-worth investor portfolio… We talk about the millionaires and the billionaires and all these guys, so what do they invest in? You take a look at their portfolio. What do they invest in the most? Out of their entire portfolio, about 20% of their portfolio is equities. That’s it. Only 20%. Where’s the rest of it? It’s in cash, real estate, and bonds. Why is it in cash, real estate, and bonds? Because those have guaranteed payments at the end of the day.

(00:43:11):

If I want a piece of real estate, I know what the value of that real estate is, and when I sell it, I’m going to get the value of my real estate back, right? Land always has a value. Real estate always has a value. Investing in real estate is always one of the better things you could do. Now, you may not make as much as the stock market, but it has a quote, unquote, “rate of return” built into it because of the value of the underlying asset. Bonds have a return of principle function on them. When I buy a bond today, I can tell you to a penny exactly what my return will be at maturity. If that maturity’s three years from now, five years from now, whatever it is, I can tell you exactly to the penny what my return will be. You cannot do that with an equity. A treasury bond will never go to zero. An equity can.

(00:43:57):

While the market tells you and while the television tells you that as an investor, you need to be a hundred percent equities because you got long-term time rise, and the reason they tell you that is because that’s how they make money. You always got to remember the motivation between Wall Street and you. Wall Street is not there to make you money. You are there to help Wall Street make money. They need to sell you product. Wall Street develops product. The more you demand a product, the more product that they will produce. This is why in 2020, 2021, we saw SPACs, the special purpose acquisition companies get brought to market because they couldn’t get IPOs out the door fast enough because there was so much demand for product, they had to come up with another way to bring product to market, so they did the SPACs.

(00:44:37):

As long as there’s demand, they’re going to bring you product. It doesn’t mean it’s good product. I mean, a lot of the IPOs and SPACs that came to market were complete crap, but people were buying it because there was so much demand in the market because everybody was speculating to make a return, and that’s not worked out very well for investors, unfortunately, which is always the case. IPOs, you should never invest in IPOs. You should never invest in SPACs. If you want to make money long term, leave those alone. Let the IPO come out, give it two years, then take a look at it, see how it’s doing technically, see what the fundamentals are, see how the CEO deals with the markets and reporting, and you’ll make a much better investment over time.

(00:45:13):

But again, what bonds do is when I buy a bond, that company, as long as I’m buying a good quality company, if I’m buying an Apple bond… Right now, you can buy an Apple bond, make four and a half, 5% on an Apple bond, right? Doesn’t sound like a lot, but what I get back is I’m going to get that 5% a year, just assuming it’s 5%. Assuming it’s 5%, I’m going to get 5% of my money every year, and at maturity, because Apple has about a hundred billion dollars in cash, they’re going to pay off that bond in three years. I’m going to get all my money back.

(00:45:40):

Now, if interest rates go up, the value of that bond goes down, right? There’s inverse relationship between interest rates and bonds. But I don’t care because if interest rates went to the moon and my treasury bond or my Apple bond goes to 50 cents on the dollar, I don’t care as long as Apple’s holding a hundred billion dollars in cash because at maturity they’re going to give me a hundred cents on the dollar back for that bond. That’s not what happens with an equity. If I lose 50% of my money on my equity, that’s all I got. I’ve only got 50 cents. If you take a look, the reason that high-net-worth investors buy bonds is because they lower the volatility of your portfolio, they give you a guaranteed rate of return.

(00:46:20):

Now, I’m going to tell you, I’m going to give you three factors for every investment, and when you analyze your portfolio, you’ve got to ask yourself this question. When I’m going to buy any investment, you can only have two of three factors. I can have safety of my money, I can have liquidity of my money, and I can have return on my money, so appreciation. You can’t have all three. You can never have all three. You can only have two of three of these items. So, when I look at cash in my portfolio, what does that give me? That gives me safety and liquidity. I now have opportunity to buy something. I don’t get paid much for safety and liquidity, but I have opportunity that allows me to buy something at a deep discount in my portfolio to make a worthwhile investment.

(00:47:04):

If I own stocks, that’s great. I have liquidity in return, but I have no safety. If I buy bonds, I have safety and I have return, but I have no liquidity because theoretically I don’t actually have to hold a bond to maturity, but in theory to have that guarantee of principle, I have to hold a bond to maturity. So, I give up liquidity for that safety. All these factors, when you look at your portfolio, say, “What am I trying to achieve?” and if you say, “I’m owning a hundred percent stocks because I’ve got a 20-year time horizon,” let me give you a good example of how this doesn’t work for people. In 1999, that was the same argument that was made for individuals. Oh, you’ve got a long-term time horizon. Let’s do some math here for a moment. Rebecca, don’t be offended. How old are you?

Rebecca Hotsko (00:47:47):

I’m 26.

Lance Roberts (00:47:49):

Okay. See, you’re young. You’ve got your life ahead of you. It’s 1999. You’ve got your money in the market. You’re a hundred percent equity. 13 years later, you have the same amount of money, not accounting for inflation, that you had in 1999. Now, you’re 39 years old, you have not made any progress on your retirement, but you owned a hundred percent equities the whole time because that’s what the market told you, right? That’s what analysts told you. See, what we don’t realize, and when people say, “Well, you’re young, you’ve got all this time horizon,” if you buy something overvalued and you spend 20 years of your lifetime staying basically even and not making money in the markets, you have lost the most valuable commodity you have which is time.

(00:48:33):

Yes, eventually your stock portfolio will go up and you’ll make some money. You see that a lot. Well, if Timmy just bought the top of every market, he still made money, right? That’s great. But what they forgot to tell you over that 100-year period is that Timmy died four times, right? We don’t live forever, and so, the most valuable thing that we have for us as an individual is the commodity of time. And so, we need to make investment decisions based on the time you have until your financial goal, when you need your money, and so, for people that are, and again, most people don’t actually get to the position in their life because they’re having kids, they want to buy a house. I’ve got four kids, I’ve got a wife.

(00:49:15):

For most people, they get into their mid-forties before they start seriously saving money because they’ve been raising kids, sending them to school, buying cars, buying houses, all those type of things. That’s where all their capital’s going, and so, they don’t serious about investing until they’re 45 or later, and this is why when you look at statistics, the average American has less than $500 in the bank. The average 401(k) balance is less than one year’s income at about $55,000 or so. They haven’t done a great job saving. And so, if I lose 20 years between now and 20 years from now making no money, now I’m at retirement, and I’ve made no money.

(00:49:51):

This is what happened to a lot of people in 2000. They were near retirement, had all their money in the markets, lost 50% of it, got back to even, now they’re back to where they were seven years ago. They lose half of it again, then they finally get it back, and now they’re retired. Right now they need that money, so all that growth they were promised, that 6% growth rate they were promised on an annual basis, that’s gone out the window because they overpaid for stocks to start with, and that’s where we are. I’m not saying that that’s going to be the outcome over the next 10 years, but that’s what valuations tell you.

Rebecca Hotsko (00:50:26):

Okay. That was super helpful. I didn’t expect us to go into bonds today. I am wondering, you mentioned long-dated bonds, but then you also mentioned corporate bonds. How should we think about the two? Should we maybe be looking into government bonds or corporate? How do you think about the two? Which are maybe better?

Lance Roberts (00:50:46):

Look, there’s opportunities that occur. Bonds are like anything else, right? There’s different types of flavors of bonds. They have different things that affect them. If you want guarantee of principle and you want to a return, you buy treasury bonds. If I had my portfolio right now, if somebody came to me that was 26 years old and you said, “Lance, what should I do with my money right now?” I would say go buy a hundred percent of your portfolio in long-dated 10-year treasury bonds. Because if I’m right about what’s going to happen economically and financially over the next year, what will happen is that stock prices will come down, some event will occur because the Fed Reserve is hiking interest rates, right? They’re going to create some type of recession economic event, and what will happen then is they will go back to dropping rates to zero. When they drop race to zero, the 10-year treasury yield will go from 4% back to basically almost zero. That’ll give you about a 60% appreciation in the treasury bond over that period.

(00:51:45):

Then you sell your bonds at a nice gain, and now you buy discounted equities because at this point you’ll be in the middle of the bear market, the recession, earnings have come down, valuations will have reverted, and all the appreciation and bonds will be gone because interest rates will be close to zero, so they can’t go up anymore in price. So, you sell those bonds for a capital appreciation, then you buy your stock values, and that’s where you start buying your deep discounted value stocks, and this is where you look for corporate bonds of good quality companies that have strong balance sheets because during a financial selloff, people will sell both stocks and bonds, corporate bonds. They’ll kind of sell baby with a bathwater. Oh my gosh, Apple’s lost 50% of their value. I’m not saying this is going to happen. Example, Apple loses 50% of its value. Oh my gosh. They’re not going to be able to pay their bonds, right? So, they sell both, and that brings down the price of the Apple bond because of that. But look, Apple’s sitting on a hundred billion in cash, those are money good bonds, right? All day long, Apple will pay their bonds.

(00:52:44):

You buy those bonds at a discount, those bonds will mature to face value which will give you a very nice capital appreciation of 6, 7, 8% on those bonds, plus you’ll be buying your discounted equities with a 4%-plus dividend yield, and you’ll be able to hold that for the next five, six years and make a very nice total return coming out of that. But again, bonds play a very important part, but you got to understand where you are in the cycle, both credit-wise as well as market-wise, and that’s a whole show we could do just on that.

Rebecca Hotsko (00:53:14):

Now I have so many extra questions. One thing on the bonds, do we care more about what the bond is currently yielding, or do we care more about price? I guess, are we going for the capital appreciation with the bonds or that income from the yield?

Lance Roberts (00:53:30):

It depends on where you are in the markets. Right now, yields are high because of inflation and what’s happening with the Fed so the prices of bonds have come down a lot. Right now, I’m buying discounted bonds because when the Fed reverses course, those bonds will go up in price and yields will come down. That’s the trade that’s coming up over the course of the next year, most likely, right? That’s a pretty reasonable, there’s no guarantee, but a pretty reasonable expectation of a trade.

(00:53:59):

When you buy a bond, you never look at coupon, doesn’t matter what the coupon is. People do this all the time. They say, “Oh, I found this bond in the market. I’m getting a 5% coupon on it, or a 7% coupon.” What the coupon tells you is how much risk you’re taking in the bond. If GDP growth is 2%, and you’re paying, or a bond is paying you 8% to own it, that’s called a high-yield bond, and the reason you’re getting that premium is because the risk of default, them not being able to pay you the money back is very high. So, you’re getting paid a premium for the risk you’re taking of nonpayment. Never look at coupon other than understanding the risk you’re taking at owning the bond.

(00:54:37):

The only thing that matters is what’s called the yield to maturity, and that factors in the price you’re paying today for the bond and the coupon that is paying. And a lot of people come to me and they’ll say, “Lance, I found this great bond. I’m getting an 8% coupon.” I go, ‘What’d you pay for it?” And they go, “Well, I paid 115 for it,” which means they paid $15 over face value for that bond, and so, you do the math, and the math is they’re getting about a half a percent yield to maturity because that’s what the market was yielding at the time. Yield to maturity will always reflect what the overall market is.

(00:55:12):

Understand, again, bonds can get complex pretty quickly. Bonds are actually very simple. It’s a little bit of math, but if you can understand the basic math and kind of understand the basic parameters of how bonds work, they can be a very lucrative investment in your portfolio, plus they can provide stability, lower the volatility, and lower your risk profile of your overall portfolio over time.

(00:55:33):

Now we’re talking about individual bonds. We’re not talking about bond funds, Bond funds, bond ETFs, they do not mature. They do not have the same capacity as owning an individual bond, and the reason you own an individual bond is because if everything goes wrong, if you buy a 4% treasury today, and next year I’m entirely wrong and interest rates go to 8% and the price of your bond falls 30%, it’s okay. You’re still going to get your 4% interest and that maturity, you’re going to get paid all your money back. You will not lose any principle unless you just sell early. But that’s the advantage of owning… Now on an ETF, it just goes down in value and that’s it, and you have to sell it for whatever it is, but a bond always gives you that return to principle function at maturity.

Rebecca Hotsko (00:56:19):

Okay. And then I guess the last thing I want to ask you is do you recommend, I guess, the 10 year longer term bonds versus short term, because the longer ones are more sensitive to interest rate hikes and falls, I guess?

Lance Roberts (00:56:36):

Right. Right. It depends on what you’re trying to do. I got asked a good question the other day, I was doing an interview and the interviewee asked me, he says, “Well, if you could own just one asset, just one, what would you own?” I said, “Bonds.” Hands down every time I own treasury bonds, and whether it’s inflation, deflation, if I could only own one, right, I don’t have a choice, what would that one asset be in both inflation, deflation, economic recession, economic growth, I’d buy treasury bonds. Now, during inflationary periods where you have surging rates of inflation, this is what you’d do previous to where we are now, you buy shorter duration bonds because I buy a bond at three months or six months, it matures every six months and then I can ladder up to the next higher rate. So, as interest rates go up and inflation goes up, I just keep laddering up on those rates.

(00:57:22):

Now we’re to the point to where most likely inflation has peaked, and the Federal Reserve is pretty much, they’ve already said they’re going to raise to four, four and a half percent, they affect the short end of the curve. The long end of the curve is not as affected by what the Fed does. The long end of the curve, the 10-year, the 20-year, the 30-year treasuries are more affected by economic growth and activity. Those have most likely hit peak values or peak yields on those side.

(00:57:47):

The reason I now want to switch from buying short duration inflation bonds, I now want to switch to long duration bonds because now I’m going to play a deflationary trade in the economy expecting inflation to come down, economic growth is slow, moves into recession, that means that yields will come down, prices will go up. And the reason I want to be longer duration, to your exact point, Rebecca, is that the price is now more sensitive to that fall and interest rates as interest rates go down, the price of longer duration bonds go up faster than what happens on the short end. I now want to shift from the short end of the curve to the long end of the curve for a trading opportunity against an economic recession.

Rebecca Hotsko (00:58:27):

That is so helpful. It’s just so interesting to hear that and kind of the opportunities because I think that we are kind of told that you can’t make as much money in bonds as younger investors, but that was really helpful to hear that insight from you today. Before we close out the episode, I know we could keep going about this, I could keep talking to you forever about this, where can the audience go to learn more about you and your work? You have a podcast, a newsletter, let them know where they can find you.

Lance Roberts (00:58:58):

It’s really simple. It’s all in one place. Just go to realinvestmentadvice.com. We post a blog there three times a week. You can subscribe to our weekly newsletter, it’s free. We have our daily podcast that we put out every day as well. I do another thing called Three Minutes on Markets & Money that we put out as well, just talking about where the market is today, what’s going to happen. We also post out a daily market commentary every morning. We deliver it to you by 7:30, tell you what the kind of the trade setup for the market is, do we expect a rally, do we expect to sell off, what we’re doing with our portfolios. Yeah, it’s all there. Realinvestmentadvice.com, it’s pretty easy.

Rebecca Hotsko (00:59:31):

Thank you so much, Lance. That was such a great conversation.

Lance Roberts (00:59:35):

Thank you. I’m glad to do it and do it anytime.

Rebecca Hotsko (00:59:38):

All right. I hope you enjoy today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or review. This really helps support us and is the best way to help new people discover the show, and if you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP finance tool which is a great tool to help you manage your own stock portfolio. And with that, I will see you again next time.

Outro (01:00:16):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consultant a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.