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PODCAST: OVERVIEW OF QUARTERLY TOP 10 LIST

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  • Transcript

    Introduction:

    Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jeffrey Mills, chief investment officer at BMT wealth management.

    Jeff Mills:

    Okay, well, welcome back to our podcast series. I feel like we haven’t done one in quite some time. We were doing one or two a week in the midst of the market meltdown in March and April, but taking a little bit of a break, but thought this was a good opportunity to jump back on and get to speak with everyone. Now that we’ve reached mid year and we published now what is our second annual mid year, top 10 list. So I thought it would go through just some of the pertinent information from that list and try to lay out some of the things that we think are most important for the second half of 2020, and what has proved to already be an unprecedented year. For the full publication, we did send it out about a week ago, but if you haven’t seen it, please reach out to your BMT investment advisor.

    Jeff Mills:

    But just as a reminder, we covered 10 different areas that we think are really important and should be top of mind for investors or at least are top of mind for us in terms of where we’ve come over the past couple of quarters and where we think we’re going. So I quickly just run down that list. I’m certainly not going to cover every one of these elements but we talk a little bit about our investment philosophy and we had a really good real-world reminder of why our philosophy is what it is when the market sold off so quickly in February and March. We’re gonna talk a little bit about the road to recovery. Look at the economic and market fundamentals as we see them today. We talk about the possibility of a blue wave on the horizon. Just looking at current polling and thinking about the election coming up and what that might mean for markets.

    Jeff Mills:

    We look at growth and value. We’ve had an unprecedented run in growth stocks versus value stocks in 2020 afterward. It’s already been a great 10 years for growth. So we dig into that a little bit. We also talk about real estate. Real estate investment trust is an example, a really common way to invest in real estate for clients and the public markets. We do recommend an allocation to REITs in our strategic asset allocation. So diving in a little bit, because I think many perceived, this is a dangerous time to be in that asset class, just given what’s going on with retail and office space. So we break down the exposure there a little bit. We talk about the Federal Reserve and the impact on rates in the yield curve. We talk about corporate debt issuances. So I have a little bit about the work from home environment, some of the winners and losers there.

    Jeff Mills:

    We also touch on the rising tension between the United States and China and what some of the investment implications might be there. And then finally, we talk a little bit about investing in volatility in our strategic asset allocation. We have a small unconstrained allocation and a part of that has been implemented in investing in volatility as an asset class. So we talk a little bit about some of the pitfalls and how we choose to sidestep those in the way we invest in that asset class. So again, certainly not going to take time to jump into all of those topics, but those are all covered in the 2020 mid year, top 10 list. So if you’d like to take a look at one or any of those topics in, in more detail, please reference that publication. But I did think it was a good idea to start off with taking a look at our investment philosophy and touching on the real world reminder that we did get when the coronavirus reared its ugly head and the markets reacted in kind, but if you rewind all the way back to the final Monday Market Insights piece that we published in 2019, we asked what we thought was a pretty simple question.

    Jeff Mills:

    And we said, how should people think about investing amid the realization that unpredictability is always a feature of financial markets? In hindsight, that was probably the best question we could have asked. And now this year we’re dealt, we’re dealing with this market that is obviously as unpredictable as ever. And, you know, we doubt that a global pandemic causing really the most abrupt economic slowdown of our lifetimes was a feature of many 2020 investment outlooks. It certainly wasn’t a feature of ours. But here we are once again faced with the challenge of investing in a world that really does feel as uncertain as ever. So the question is, what do you do and how do you prepare for such environments? And we really try to go back to our investment philosophy and successful investing in our view always starts with having a plan.

    Jeff Mills:

    And we think that constructing a proper proper plan always starts with a really high conviction investment philosophy and our highest conviction belief is that successful investment outcomes are most often produced by finding an approach you can stick with. We really don’t believe in making radical changes based on the prevailing market drop backdrop. And we think that a diversified purpose-built asset allocation is foundational in any investment plan. So because of all of that, we start by acknowledging the fact that we can’t predict market performance. We can’t predict asset class leadership. It’s extremely difficult to do so with precision. So really making sure that each portfolio has thoughtful exposure to a lot of different asset classes is the most powerful way to avoid some of the behavioral traps that so often do derail a solid investment strategy. So we think taking these simple tenets that allows an investment plan to be built for the long term and to be built for survival.

    Jeff Mills:

    Now I think we all have to acknowledge that, although that seems really simple. I think adhering to a particular investment plan in the depths of a market panic is extremely difficult — and this year, certainly a real world test of that. We had the fastest 30% market decline in history. And I can’t tell you how many conversations I’ve had with clients over the past couple of months, talking about dramatically reducing equity, exposure, selling all of their stocks completely in their portfolios. You know, I think this time always feels different and always feels scary. So again, sticking with that plan can be extremely difficult and most of those conversations happen right when the S&P 500 was near its bottom, but you’ve heard me say it before, but that’s what humans do best. And we panicked exactly at the wrong time, especially when it comes to investing.

    Jeff Mills:

    And I think that although during these times inaction might feel like apathy or incompetence, even, it really is most often the proper prescription. And I think trying to provide that relevant perspective during those times is the greatest service that we do to clients. So, you know, for an example, and we include this in our monthly market slide deck that we present to clients, and we use this in some of our publications in early April, but if you go back to early April, things still looked quite grim in the marketplace. The market had just recently bottomed, although we did not know it at the time, but what we tried to do is help investors pull back the lens to ease the pain a little bit. And we did that by simply looking at what we call a balanced portfolio of 70% equities and 30% bonds

    Jeff Mills:

    And we said, if you had a, that type of portfolio invested over the prior 10 years, it’s still would have produced an average annual rate of return of 8.2%. So to give you some context, if you had a million dollars invested 10 years ago, it would have grown to nearly $2.2 Million near the depths of the equity market sell off at the beginning of April. Now, the problem is that was down from a peak in that portfolio of $2.8 million in 2019. So we all anchor to that recent peak and it’s a form of recency bias. And I think that clouds our perspective and even specifically looking at stocks: in April [2020], when we had not recovered all that much stocks, it’s still average 9.6% on an average annual return basis over the most recent decade. And that compares quite favorably to history.

    Jeff Mills:

    If you go back to the mid 1950s, the average annual return through the end of 2019 was about eight-and-a-half percent. So even after that big market drop, stocks is still performed better than the average over the most recent 10-year period. So I think making sure that we pull back our perspective and understand that even in the depths of something that feels extremely uncomfortable not that much should have changed as it relates to your long-term financial plan, whether you’re thinking about retirement, whether you’re thinking about paying for college or whatever the case might be, you know, even at the market lows, your plan was likely very much intact. So again, I think having that perspective is, is really important. And now, obviously we know this, but stocks have increased over 40% since that March 23rd bottom. Now, you know, of course we did not predict this, but that’s almost the point here.

    Jeff Mills:

    And it’s that predicting those near-term market movements with any degree of certainty is incredibly difficult. And if you have an investment strategy that’s predicated upon timing, those kinds of movements, it’s likely doomed to fail, because not only is getting out at the proper time challenging, but buying back in can be equally as hard. And that often results in leaving significant returns on the table. And for most investors, that kind of thing failed market timing can really be lethal in terms of reaching your long-term investment goals that are needed to drive a success overall financial plan. So just to go back to some of our foundational principles and what this all should remind us of is diversification. It’s being patient. And it’s reversion to the mean in terms of, you know, good times, good times don’t last forever, but neither do bad times. So we always, we always remind ourselves of these foundational principles.

    Jeff Mills:

    I feel like we talk about them a lot, but this is a perfect real-world example of why they’re so important. The last thing I just wanted to touch on, before we wrap up this quarter’s podcasts was some economics fundamentals looking at the market and thinking about the road to recovery. So we have that foundational base there, we have that perspective and philosophy, but of course that doesn’t mean that we’re not acutely aware of what’s going on within the economy and the markets and trying to assess what the situation is. So if we do want to make changes around the edges we have a good process and plan for doing that. And I think what we’re looking at right now are some early signs of an economic recovery. And I think some of that starting to become clear and I think the financial markets, in a way, are already pricing in a fair bit of the incremental improvement that we’re likely to see from now through the end of the year.

    Jeff Mills:

    So I think that’s, that’s really the key element in terms of figuring out how the economy and how the markets are lining up. So the economy is starting to recover off the bottom, but it’s quite a steep contraction. And I think the financial markets have run a little bit ahead of the economy. So even the incremental improvement that we’re likely to see from now until the end of the year, it’s very likely that stock prices reflect a lot of that improvement. So how much of that is going to drive the stock market higher to new highs and beyond? I think that’s the big question. But we are seeing evidence of recovery. So, you know, let’s start there because I think it’s encouraging to see the economy stabilizing. So whether you’re looking at manufacturing, housing, we do believe that the worst of the economic contraction might be behind us.

    Jeff Mills:

    So whether you’re looking at retail food and services sales, whether you’re looking at manufacturing, PMI employment the NHB Housing Market Index, all of these things have shown some signs of stabilization. And I think that’s particularly encouraging because stock prices reflect the anticipated future. They don’t reflect the past, they don’t reflect the present, but I think the concern as I alluded to is that financial assets have recovered most of what was lost, but the economy has not. And it is possible that current stock prices are reflecting a reality that actually might take longer to materialize than many investors hope. And I think that’s the big risk right now. If investors to become disappointed by the speed of the recovery, I think stock prices might find it difficult to make meaningful progress from current levels. And again, it’s very difficult to predict, but we have seen the market shop around for the better part of six weeks.

    Jeff Mills:

    Now, if you go back to the beginning of June [2020], after that big run off the bottom. We have a chart in the outlook, which obviously you can’t see it now, but it does show the extent of the current disconnect. Usually you have stock prices move with a very high correlation with leading economic indicators, things like housing, consumer confidence, manufacturing. And now what you have is V-Shape recovery in the market, and only a very small recovery in some of those leading economic indicators. So it’s really the biggest divergence that we’ve seen between leading economic indicators in stock prices in a very long time, if ever, quite frankly. And we’re also seeing that disconnect between stock prices and corporate earnings. We have another chart that, that shows that disconnect quite clearly, but if you go back over the last 20 years, the S&P 500 has had a 0.9 correlation with 12 month forward earnings in the S&P [500].

    Jeff Mills:

    So just to get gave you perspective, if the correlation was one, that means they would move in lock step. So pretty close to lock step. But since the market bottomed on March 23rd, that correlation has been negative 0.9. So the market has recovered higher earnings expectations have continued to come down. They have stabilized some, but still that major gap. So simply put as, as the market continued to rise, earning estimates continue to fall. And we think that the historical relationship is going to reassert itself. And obviously this can happen in one of three ways: the markets can fall, earnings estimates can rapidly recover, or you get some combination of the two. In any case, I think we should be clear on what equity markets need to continue to appreciate in the near term. And that is significantly higher than average price-to-earnings multiples. So for context, as I’m recording this, the S&P 500 is currently trading at about 22 or 23 times earnings expectations over the next 12 months.

    Jeff Mills:

    So this represents the highest forward price-to-earnings multiple that we’ve seen since the tech bubble. And obviously that was over 20 years ago. And it usually does take out three years for earnings to recover and reach their previous peak after an earnings recession. And right now in 2021, current expectations are that earnings will exceed the earnings that we saw in 2019. So that would be an extremely rapid recovery if that were to actually materialize. So our anticipation is that earnings expectations for 2021 start to come down a little bit. So again, if the markets continue to rise, and earnings expectations for 2021 do fall from current levels, that means that the market is going to have to maintain a higher and higher valuation or a higher and higher price to earnings ratio to continue to make progress forward. So it’s pretty easy, I think, to make the bear case for stocks right now. The problem is I think investing in this environment is more complex than that, because on one hand, we believe the economy is in the early stages of healing.

    Jeff Mills:

    We talked about that. And you also have the support of both monetary and fiscal policy makers. The Fed has stepped in, they’re obviously going to do whatever it takes. And I think it’s very likely that at some point we’re going to see additional fiscal stimulus out of Washington. I think if we don’t that would be a big stumbling block for the market, because I think in many ways, that is part of the calculus of the current price levels. You know, over the next couple of years, I think things are likely to get better, not worse. So that’s also another plus for the markets. So in terms of, of already surpassing that economic low. But on the other hand, we also think that the healing in the economy in terms of 18 million people still being unemployed and, you know, all of these issues that could linger for quite some time that could mean that the recovery of the economy is much slower than what many are hoping right now, even if we do get a vaccine, even if things do get back to quote unquote normal in, in somewhat quick fashion.

    Jeff Mills:

    And I think there are numerous potential risks and pitfalls as we move through the rest of the year. And right now I think our positioning reflects this tug of war that I’m describing. So, within equities, as an example, we have tilt toward cyclical oriented assets classes that should benefit from economic recovery. And right now those asset classes are unusually cheap. And you see things like large cap growth technology; these areas of the market that have performed so well, that in many ways are holding up the market right now are incredibly expensive relative to those cyclical areas of the market. So we know the economy will recover. And when it does, we believe that, in a sense, those asset classes that I’m describing a, whether it’s financials, industrials, just mid cap and smallcap, stock value in general, it’s really spring loaded to do very well.

    Jeff Mills:

    Once we do reach that point in time. The problem is we don’t know when that point in time is going to be. So we want to have exposure now and make sure that we’re positioned for that ultimate recovery. However, to manage the heightened level of risk that I’m talking about, we’ve decided to reduce overall equity exposure relative to whatever your stated target is. So if your portfolio is 70/30, we represented taking back your equity exposure a little bit from 70% to about 65% just to soften the blow. If the market is to hit another, a heightened state of volatility, which we do think is likely over the next quarter or so. So, you know, should the gap between fundamentals and asset prices that I’m describing persist longer than investors currently anticipate, then at least that extra cash that I’m talking about in portfolios would serve as a hedge against some of those other more cyclically-oriented equity exposures..

    Jeff Mills:

    So that was what I wanted to cover. There’s certainly much more in the quarterly, in the Top 10 that I laid out in the beginning of the podcast, but I think those are really the two most important elements. It’s the philosophy, it’s the thought process behind dealing with portfolio management in such an unusual time. But then it’s also thinking about some of those fundamentals and what the setup looks like for the rest of the year. And I do think the setup looks like an economic recovery, but I also think the economic recovery may be slower than the market is currently pricing in. So that’s why we’re positioned the way that I just described. So I hope that was useful as always reach out with questions either directly to me or to your investment advisors. I always enjoy recording these podcasts. I hope everyone is staying safe and staying well. Take care. Bye bye.

    Closing:

    This has been a production of Bryn Mawr Trust. Copyright 2020. Visit us online at bmt.com forward slash wealth. The views expressed here in are those of Bryn Mawr Trust as of the date recorded and are subject to change without notice. Guest opinions are their own and may differ from those of Bryn Mawr Trust and its affiliates and subsidiaries. This podcast is for informational purposes only and should not be construed as a recommendation for any product or service. BMT Wealth Management provides products and services through Bryn Mawr Bank Corporation and its various affiliates and subsidiaries, which do not provide legal, tax, or accounting advice. Please consult your legal, tax, or accounting advisors to determine how this information may apply to your own situation. Investments and insurance products are not. Bank deposits, are not FDIC insured, are not backed by any bank or government guarantee, and may lose value. Past performance is no guarantee of future results. Insurance products not available in all States. Any third party trademarks and products or services related thereto mentioned in this podcast are for discussion purposes only. Third party trademarks mentioned in this podcast are not commercially related to or affiliated in any way with BMT products or services. Third party trademarks mentioned this podcast are not endorsed by BMT in any way. BMT may have agreements in place with third party trademark owners that would render this trademark disclaimer not relevant.

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