With rising inflation and now an inverted yield curve, are we headed towards a recession? The interest rate paid on our short-term debt has exceeded the interest paid on our long-term debt of the same quality. So, what does this mean for investors? On today’s episode we’ll unpack the inverted yield curve, the concerns investors should be aware of, what to anticipate for the remainder of the year, and the strategies you can implement to protect your plan now and in the future.
This inverted yield curve and a contraction in the market could indicate a coming recession, but this is not absolute. We are in a unique situation as we usually don’t see rising interest rates and a contraction in the market at the same time. Typically, when markets contract on the equity side we can find safety in bonds but with rising interest rates that might not be the case this time. However, it’s always important to keep your perspective in check and prevent yourself from making quick, emotional reactions to the market.
The best move to make right now may to be make no move at all. We want to take a long-term view when it comes to our plan. Don’t let news cycles scare you into making poor decisions. If a recession does happen it doesn’t ensure the U.S. stock market will underperform but it’s still important to be prepared. With this volatility, it’s essential to have a balanced portfolio that outpaces inflation while simultaneously withstanding market turns.
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Timestamps (show notes):
1:45 – The yield curve has inverted
5:02 – What is the best move going forward?
10:12 – Inverted yield curves impact on stocks and inflation
19:14 – Inefficiencies of mutual funds, strategic sorting, yield splitting
23:34 – Having a blend of value and growth
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Welcome to Retirement Talk, the Redefining Wealth show, your source for financial information, specifically for pre-retirees and retirees. We are here each and every week to help you better navigate during these economic times. We are here to discuss thoughts and ideas in the field of finance and retirement, as well as discuss trending topics that could impact your bottom line. We will break it all down. These discussions can help you make better informed decisions so you can make better financial choices and live the lifestyle you imagine for retirement.
Laura Stover is a registered financial consultant and CEO of LS Wealth Management, as well as founder and owner of LS Tax, a consulting firm. She’s been featured in Forbes, CNBC and The Wall Street Journal. I’m Ron Stutz. Our topic of discussion for today is the yield curve just inverted, are we headed for a recession? All here on Retirement Talk. Now, here are your host for Retirement Talk Laura Stover along with certified financial planner Michael Wallin.
Hello. Hello. Hello. Welcome to Retirement Talk, the Redefining Wealth show. And another addition with a great show on timely topics, top of mind topics that a lot of clients have questions in terms of how will this affect my financial planning? How should I be looking at this? We have so many wonderful people that I am finding out listen to us each and every week, Michael, and I’ve had the opportunity to speak with number of them over the last several weeks. And we’re going to hop right into this week’s show, which is from an article called Of Dollars And Data.
And I came across this information, it’s basically, we’ve had a lot of clients asking about the yield curve just inverted, are we headed for a recession. So with all of the discussions surrounding inflation, I thought this was a very timely topic, as really since August of 2019, when I did some research, the US economy in 2019 saw a yield curve inversion, and all that means is, this is the interest rate that’s paid on our short term debt, it actually exceeded that interest paid on the long term debt of the same quality. So we want to, as Michael would say, unpack some of this, and what some of the concerns are for investors? What should you anticipate the remainder of this year and things that you can implement into your financial plan this year, next year and beyond? And let’s just hop right in and talk about this yield curve, Michael. What’s your thoughts on it?
Well, it is definitely a key indicator that we look at. It is not an absolute, as you were saying. So when we’re looking at an inverted yield curve, I think that the fact that we’re seeing a contraction in the market today, as we’re doing this episode, we’re also seeing a contraction on the 200 day moving average, which we could be back below a triggering event for a lot of tactical managed accounts. When that is coupled with an inverted yield curve, that does give an indicator that we could see a continued contraction in the market.
But again, it is not an absolute. We are in a very unique scenario this year, as we’ve seen the contraction in the market, but we’ve also seen a rising interest rates. That is unique because we typically don’t have those two scenarios working together at the same time. So typically, as markets contract on the equity side, we’ve always been able to flee and go into the bond markets as a safe haven. Unfortunately, through the first quarter of 2022, as we’ve seen a contraction in the equity markets, bonds have not been a safe place to go to. We’ve talked to many of our clients over the last couple of weeks, and as we were looking to take them from a tactical positioning going into the bond markets picked up an extra 100 to 200 basis point loss. So that is a unique scenario.
So even though we’re seeing an inverted yield curve with a contracting market, it is a different time. In this situation, we’re having to look at where are we projecting the markets going and not taking a knee jerk reaction to quickly move out of the market and end up costing individuals either on capital gains due to non-qualified accounts, or losing asset value because we are sitting on the sidelines as the market starts recovering.
Yeah. And it’s so easy to see some investors, not all investors, but some investors, every time a headline news comes out about something, or the emotion, the emotional part… Obviously we’re all human, we should have some type of an emotional reaction to various news that triggers fears within the human psyche. And that’s a great topic for another show with some of the reasons people do the things they do. We can have a lot of fun with that one. But good perspective there, because investor concern, maybe they hear this on the news, historical data has shown that the yield curve inversion, it can, as you stated, be a predictor of a looming recession.
There’s been a little chatter, a little noise that this could potentially be more likely in 2023. But what does Warren buffet say? Be fearful when others are greedy, greedy when others are fearful. So again, it’s keeping a perspective when various things happen. I can assure you, nothing stays the same, whether it’s good or bad. There’s always changes. And it is part of life. But the way we have our framework in place, that’s why we talk about the Redefining Wealth process on an ongoing basis, having that framework and the plan in place that’s adaptive to these changes is really an intricate part of being successful in the long term, because these things come and go, but there’s ultimately no guarantee. But it just doesn’t mean the worst case scenario necessarily for the market.
So we kind of say, hold your horses. And if we look over the past four plus decades, we’ve experienced, I counted about six yield curve inversions, five of which followed with a recession one or two years later. And beyond that, the last yield curve, which was 2019, resulted in no recession. No recession after 2019. Actually we’ve had two, we had COVID in there, but we had a great bull market in 21. Yes, a lot of money infused in to the economy, which probably contributed to that to a certain degree. But stocks have risen 68% since that timeframe.
So if you think it’s time to sell off and move to bonds, as you stated, take a pause. If you look at the stats, US Treasury bonds are just as likely to underperform as stocks following an inversion. So that means the best move to make right now could be no move at all.
I am more concerned about supply chain issues and inflation rising those cost on goods and services more so than I’m concerned about an inverted yield curve. Simply looking at companies that pay dividends, if you’re going to be in a stock market, you’re choosing companies that you would like to invest your money in and become a equity owner in those companies. And I would have to believe that most of the people listening to the show are probably looking out there and saying, “What’s a company that has a high probability of selling a product and making a profit because I’m going to get to share in those profits?”
Well, if we have supply chain issues and we have rising inflation costs, supply chain issues is going to affect the manufacturers. They’re going to raise the cost. They’re going to sell to the retail establishments. And then the retail establishments are going to raise the cost of those goods as they sell them to the consumers. It’s just basic economics. I’m more concerned about that because consumers are going to come in that may have either fixed income or their income wages may not be keeping up with the inflation adjustment and they’re going to buy less of those goods and services.
If they do, companies by natural attrition are going to draw back on their price value of the stock market. When that happens, your portfolio is going to shrink. I’m more concerned about that element of what we’re dealing with today than an inverted yield curve, because how many people are actually out there borrowing money today? We’ve got too much money chasing too few goods. That’s why we have inflation.
So how many people are actually out there borrowing short term money against long term money? I just don’t think that that’s really where the mainstream America is today. And like you said, maybe we pump the brakes a little bit, we don’t get emotionally involved in some of these key factors we’ve seen historically up until today, and we take more of a long term view of where we are, but don’t let new cycles dictate emotional decisions that could either take us out of the market and cost us 10, 15% of what we have gained over the years, or turn around and trigger unnecessary taxation.
And to your point here, the article from Dollars And Data that we’re featuring today, and stay with us because we’re going to have a reemergence. I don’t have an exact timeline on it, but our weekend brief is going to be providing timely articles. We have our team working diligently on that. I know a lot of you were signing up for that information. We’re having a website makeover, a lot of good things coming. So stay tuned and listen for updates on that.
Continuing this discussion revolving around the inversion of the yield curve and a perspective, there’s a chart in this article. Every time the yield curve has inverted, a recession followed within the next few years. But just because a recession may occur within the next 12 to 24 months, it does not mean that the US stock markets are going to underperform. And since 1978, there were six inversions of the yield curve, excluding the one that we recently had. And Ben Carlson wrote a great article on this, which lists five of these inversions and when the US economy went into the recession afterwards.
If we look August of 1978, the yield curve inverted, then a recession began in January 1980. That was a lag time of 17 months. Then the next one, September 1980. I was still in high school. Very young. The recession begins 1981 in July. That was a lag time of 10 months. And the most recent one, I’ll just skip ahead, 2005 is when the yield curve inverted. The recession started not until that was the prerequisite to the financial crisis, October 2007. There was a 22 month lag time. So given this information, you may be wondering how US stocks perform after a yield curve inversion.
The long story short, not real spectacular, according to the data and the article here, but if you look at the one year performance of the US market following a yield curve inversion, you can see stocks didn’t go as well following the inversion. But in particular, after a yield curve inversion, the median inflation adjusted total return of stocks was 4.7 compared to 9%. So during all other one year periods, the number of the yield curve inversion is low, yet the point stands.
So even if we extend this analysis to go beyond one year, it doesn’t get a lot better in the examples here. But two years immediately after the inversion, the median return of stocks was still 4% compared to 8% annually over the other two year periods. When we look at interest rates now, even with the Fed raising monetary policy, 4% is still not a terrible rate of return. Yes, we want more growth over time, but compared to other, cash or other options, 4% is not that bad.
And the five years immediately after the yield curve inversion, the median inflation adjusted total return of stocks was 6% annually compared to 8% annually in all other five year periods. So I think it’s a balancing act to some degree when we look at inflation at 8.5%. The issue that a lot of clients that I’ve seen, if they’re too cash heavy, they’re not real sure what to do. And we’re seeing this with a lot of people right now. Maybe all of the volatility this year made some people nervous. What are they losing when your inflation rate is essentially at 8.5%?
When you’re looking at 8.5%, you’re looking at the difference of whether or not a person can live the lifestyle that they’ve drawn accustomed to. And the way that they avoid that is in preparation. Do you truly have a plan? And we talk about this Laura on just about every show, but it’s coming in, and really identifying when is the distribution of a portion of their investments going to come in as cash flow. So set another way. When are you going to deploy a portion of your assets to meet the gap that you need to live the lifestyle that you’ve always been enjoying?
And for those individuals that treat all of their money exactly the same, they invest it all into one investment strategy, the same amount of risk exposure on every single dollar, they’re the ones that are impacted the greatest. Because as we’re sitting and talking to our clients and we have well diversified their portfolio, not just among the different investing strategies, but we also invest it based upon time horizons, when are those dollars actually going to be executable into the overall strategy?
And if you do that appropriately, then when the market contracts, a yield curve, we look at a time period of 17 months of a contraction, as you stated in some of the numbers there, that doesn’t impact our clients because we have an expectancy that we are going to reduce the risk as that time period approaches to put that money back into use. The clients that are out there that are in a scenario where they treat all their money the same and they open up as statement and they say, “Oh goodness! My accounts, the pricing of my underlying positions are down, and my account, I’ve lost a $100,000 of account value.” They haven’t realized, it’s not an actual loss, but they’re looking at the value going down and saying, “I can’t handle that.”
That’s because you haven’t actually got an investment strategy. You’ve got your money in the market, but you do not have a plan of execution. And that’s why they need to go through the LS Wealth process so that they look at each of those pillars, when are they going to become necessary for distribution for quality of life? And that really becomes the difference. Our clients don’t have to get nervous when information is being shared like other clients do, simply because we help guide them through and navigate around these pitfalls so they’re not exposed to these kind of detrimental losses.
The rising tide that lifts all boats, and then the falling tide reveals who has been swimming naked. Don’t get caught naked. Stay the course and let the chips fall where they may. But we take that a step further and believe you need a framework in place. And if you have the framework and processes in place, this too shall pass, and you’ll better navigate through the various risks that we’ve identified with the Redefining Wealth process. We’ll continue this discussion, some more specifics regarding the market volatility, this inverted yield curve, and more specifically, plans that you can execute and implement into your strategy today. Stay with us. You’re listening to Retirement Talk.
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We’re discussing the yield curve today. And the fact that it recently inverted, we’re featuring Dollar And Data. It’s a great article that discusses this at depth. If you’d like copies of the show notes, simply go to redefiningwealth.info, and we can make that available to you. Archives of all of the shows and past shows that you may find of interest are also available there. So continuing with this discussion, essentially, the article is explaining that the inversion of the yield curve really is no longer a useful indicator. And stocks are, in fact, up over 60% following the most decent inversion, which is August of 2019. And that moving to bonds or cash are not necessarily the best choice. So best course of action is really to do nothing, as the article states and kind of what our message is on this today.
Now, more specifically, things that clients can be looking within your own portfolio construction, let’s take a look at the framework that you want to start thinking about. And if you gravitate towards this philosophy and the mindset, then we can provide some tools for you to take advantage of our LifeArc Planning System and some of the framework that we feel is important in order to create tax efficiency and strategic sorting and yield splitting methods. The article talks about these two types of ways to enhance tax efficiency within a portfolio.
Now, this has become a big point of discussion recently. Most people’s portfolios were up substantially in 2021. If it was a non-IRA account… We’ll use that term instead of non-qualified so that everyone listening is following the conversation. If you had a lot of mutual funds, for example, within your portfolio, and it was an individual or joint account, even though the market is down now at the end of 2021, you may have found yourself paying a lot of capital gains tax, which is not as bad as ordinary income depending on what your tax bracket is, but that could be as high as 20%.
And that is the turnover ratios, the cost of when the fund buys and sells position, you don’t actually own the mutual fund companies because it’s a pool of investments. So that’s one of the inefficiencies that we see happening. If you have lump sums of money, these can become very inefficient vehicles. If you’re starting out, mutual funds can be a great way to start to accrue and have a diversified portfolio, but it can be a landmine of issues going forward, both on a volatility basis and a tax basis. So let’s break this down a little bit, Michael, between the inefficiencies maybe of mutual funds, the strategic sorting and the yield splitting. That’s a mouthful.
It’s a phenomenon. It is definitely a phenomenon in it’s phantom of income. You’ve got an individual that is managing that mutual fund and their job, their responsibility, is to get the best returns possible out of that mutual fund. Sometimes, based upon research and information they have, they may sell a position that may have been very successful over a time period where capital gains have ran up under those positions. They sell those positions to move in a different direction, as the great hockey player Wayne Gretzky said, “You’re always wanting to skate to where the puck is going to be.”
You’re not looking at where the puck is today, but where do we see opportunities? So many of these money managers that are managing these mutual funds may sell off positions. When they do, those capital gains are then distributed out to each of the individuals that are participating in that mutual fund. So even though you may not have sold your mutual fund, you may not have made any trades on it, you may be getting that 1099 at the end of the year, and you’re saying, “Where did these capital gains come from? I didn’t trigger a sell.” Well it’s because you’re sharing in that mutual fund and that becomes phantom income.
And that can be a bad thing. It’s like a phantom pain if you’ve lost your arm or your leg, and it can be a little bit of a shock. Now, the other thing we see sometimes too, is too much indexing where a client thinks they’re maybe moderate or moderate aggressive, but they’re really taking a lot more risk. This can create some other issues if they’re just broadly based in following the index. Now, I think ETFs can be a great tool. But again, that can be a recipe for, when the market cycle is down, you are going up and down exactly in correlation to what the respective benchmark could be.
So a better approach, depending on what your goals are, is to maybe have that blend of value and growth. So for example, of course it depends on everyone’s specific situation, but we can really unravel a lot of this by, step one, having access to the LifeArc Planning System. It’s our proprietary system where we can get under the hood, really understand your cashflow, your expenses, and your budget.
If you had stepped into retirement last year, and then inflation now out of the blue has soared gas prices, groceries, 8.5% and still climbing and we’re still expected to be at, I think, 6.6% on core inflation next year, and you’re taking income out of your portfolio to pay for expenses, you have just increased the expenditures by over 8.5% right now. That can put a drag on top of market volatility when you’re taking out of a declining portfolio, double the withdrawal rate that you were expecting, actually more than double, because you’re, what, around two to 4% is the normal withdrawal rate, for a sustained period of time, that could really be what we would call kind of a… you get your foot in one of those mouse traps there, right Mike?
That’s right. One of the things that… You bring up index and then you made my mind start racing there. We all have heard that if we’re following the S&P 500, roughly the numbers I’ve seen is about 60% to 63% of the actual growth in the S&P 500 is actually coming out of six companies; Facebook, Apple, Amazon, Netflix, Google, and Microsoft. And it’s often referred to, if any of our listeners looking at financial publication, it’s the FANMAG.
Well, when you start seeing companies that may fall out of favor socially, as we’re seeing Netflix, as we’re recording this episode, this week has been a very high volatility time for Netflix, when we start seeing that, even though you think you’re indexing in a broad based market, the S&P 500 is not equally weighted. Those large cap gang, they are tilting the scales and it doesn’t take a lot of shifting of those larger positions to then cause that whole index to be negatively impacted.
So for a lot of people, I know I read a lot of publications, it comes back and they’re looking at the individuals that may be millennials today, or the generation right behind them and saying, “Oh, just buy an index fund. Look historically what the market has been able to achieve over the number of years.” Well, historically, that is what the market has done. But the positions of the S&P 500 today are not equal to what it has been historically over the years. And some of the companies that have started off over the last 20 years or 30 years are now trillion dollar companies that. If you take a Amazon and you look at the value of Amazon versus a blue chip company such as Coca-Cola, I think Coca-Cola is a third of the size of Amazon, but Coca-Cola has been here since the late 1860s.
So we are 140 years, 150 years, that Coca-Cola has been a product being sold. Amazon’s only been around for the last 20 years. How has Amazon grew that much faster? So be real careful with indexing because it is not something that can really fully diversify you when it’s heavily weighted to those larger capital.
I think that’s a portfolio mistake. We see more than one client over-weighting in that regard. Strategic sorting and yields splitting. So just to recap a little bit here, the strategic sorting, it involves sorting those assets into taxable or tax advantage accounts, depending on the yield of those vehicles, the tax rate, or what we like to also look at called potential tax drag. And then each asset’s allocated to a particular account with a priority of tax efficiency in mind. So in the instance of least tax efficient holdings, they should be placed in the greatest tax advantaged accounts.
And then yield splitting is just essentially the method, like our example here with index funds, the tax strategy here includes replacing them with a corresponding pair of funds. A low yield tax efficient fund, a high yield tax inefficient fund, otherwise known as yield splitting. It basically mirrors the performance of the broad based index funds in such a manner that allows new funds, low and high yielding components to be invest in two different accounts.
So in the end, funds are invested separately to maximize the overall tax savings and moves that can really be made to replace a total bond market fund. And really keeping our focus on asset allocation. I mean, that is 92.6% of how well a portfolio will do over time, and strategies where we want to maintain capital. We want to maintain tax efficiency. So portfolio construction today, by starting with our proprietary Redefining Wealth process, portfolio construction today requires not just the investment management, but the tax efficiency, the proactive tax management as well, and building that all around income.
So the key element of a good financial plan in my view is efficiency that includes tax planning, in one way, shape or form. And as far as the yield curve is concerned, hold your horses, as we said at the beginning of the show. It’s not really a big deal. But history is kind of there. I mean, short term lag, stocks have not really underperformed in any significant manner. The economy’s going to rise and fall, slow down, stall up at times, but earnings are really strong. And I think it all comes with a plan. It’s the most important. We can’t always control what wars are going to happen, what inflation is going to do, some of the policies that are in place.
We don’t really have a lot of control over those things, but what we can control is how our portfolio is constructed and making sure that a framework and a process is in place to address those six key areas of risk that we’ve identified; income, investment management, tax management, healthcare management, estate planning, and liquidity. Making sure it’s adaptable for any type of market. Thank you for listening. I hope you’ve enjoyed the show.
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