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This week on the podcast, we dig into Snap and Disney earnings; Steve Wendel tells us how to keep cool when the market is not; Christine Benz shares five to-dos for retirees as volatility returns; PIMCO's Mihir Worah says TIPS and Commodities look attractive; Schwab's Liz Ann Sonders gives her take on the market's moves; and our analysts give two dividend ETF picks; and stocks that look attractive after the energy sell-off.
Shares of Snap soared this morning after the firm finally reported a strong quarter as a public company. With some improvement in user growth and further automation of sales of Snap ads, we think the firm is slowly making headway toward providing a scalable and easily measurable platform. However, given Snap's continuing difficulty to further accelerate user growth, we remain convinced the firm lacks a network effect moat source. We see the shares as fairly valued today.
Disney shares on the other hand were up only modestly after the media giant posted inline results. The parks and resorts business saw strong 13% growth, as even Disneyland Paris contributed to growth, helping drive overall revenue growth of 3%. Management also disclosed that the regulatory process for the Fox deal has begun. We see shares of the wide-moat firm as attractive today.
We're planning a modest decrease to our fair value for Chipotle after the firm's fourth-quarter results, which sent shares sharply lower. The company remains in transition and its fourth-quarter update offered a few hints of stabilization that were overshadowed by unknowns. We're reducing our long-term margin assumptions, but that is offset by a lower tax rate and other adjustments. Shares are undervalued, but we'd recommended investors wait for a larger margin of safety before investing.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With major indexes down over 4% today, it seemed like an opportune time to sit down with Steve Wendel, he's our head of behavioral sciences at Morningstar, with some ideas about how to keep your cool when the market isn't.
Steve, thanks for joining me.
Steve Wendel: Thanks for having me.
Glaser: We all know the advice is generally don't look at your portfolio when you have a day like this, but that's really hard to do, right? Is that something we could reasonably expect investors not to check their portfolio when you see this much volatility?
Wendel: First, that is good advice. There's lots of research on how frequently checking your portfolio, especially during market downturns, can warp one's behavior and get you into trouble. But we're all human. I've been looking at my portfolio as well throughout the day, just out of curiosity. Thankfully there are a variety of things we can do to help us calm down and get back to our rational selves.
Glaser: What are some of those strategies?
Wendel: A variety of great techniques you can use. The first one is to remember that our minds play tricks on us. That, fundamentally, volatility, downward or upward, is just data. As for the drop that just happened, that's past. That's gone. There's nothing we can do about what just happened. It's really as we think forward to what will happen that our minds take that data and apply a story. If you don't know what that story is, it's probably the bias of recency bias--thinking that what just happened is about to happen. But when we think about that rationally, we of course know that's not the case. One of the things that we can do is to round out that story: This just happened; this is what I believe is about to happen; what's the rightful thing to do? For most professional, thoughtful investors, they know it means you look for bargains. Same exact data. Very different outcome.
Glaser: Let's say that you are prepared for that, but we do see a further sell-off. There's more volatility. Is there anything you can do now to prepare yourself for that happening in the future? You could be looking for bargains for quite a while.
Wendel: Yes. Absolutely. The number-one rule is to externalize. It's to get it out of your head and take your calm, thoughtful decisions now to help guide you in the future. Now a variety of ways you can do that. One of the ways you can do that is to intentionally look for friction, so if you're working with an advisor or just with yourself say, set a rule for yourself. I'm going to have a three-day waiting period before I make any change. For example, if you're working with an advisor tell the advisor that they should only make a trade if you and your spouse are there. Think of ways that you can slow yourself down from making hasty decisions. Other techniques you can use, of course, are to write out the rules you want to follow: only if the market drops by this percentage in a particular amount of time. And then you're checking those rules again and again rather than checking your portfolio and making up the story about how bad things are going to happen.
Some other techniques you can use are to look at the emotional power of your investment policy statement. Look at what you wrote for yourself--or if you haven't already written one, of course, you should do that. Write out not just what your financial goals are but why you care. What matters to you and how that expresses who you are. Then, in times of trouble, you look back at that and say, fundamentally what I care about, what I value, has it changed? Probably not. It's a counterpoint to the vivid, crazy stories that can go in our heads when we see a market downturn.
Glaser: Of course, it always makes sense to separate the real world and your real life versus your portfolio. Particularly if you have 20, 30 years to retirement.
Wendel: Exactly right. So the challenge is how do we fight vivid with vivid? We get these vivid images of a market crash, etc., but really it's only one of the things that we can pay attention to. Think about what does this mean for your goals? Probably not too much and especially in a 20-, 30-year horizon. What are the other things you have to do in your life? Play with your kids, help your family, do your job, etc. So you balance that one vivid screaming thing over here with all the other things you have to do in your life. It can help put things back in perspective.
Glaser: Steve, thanks for your insights today.
Wendel: Pleasure being here. Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the return of equity market volatility, many retirees and those about to enter retirement are wondering what to do. I'm here with Christine Benz. She's our director of personal finance, with five to-dos for those folks.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: Let's start with the first to-do, which is really to put these losses into perspective. Just take a moment to take a step back.
Benz: It can be really scary for people who are either getting close to retirement or actively drawing upon their portfolios when the market falls off as it has recently. I do think that taking the very long view on your portfolio is crucial. Remember that we've had a great runup since 2009. If you're happy with where your portfolio stood at the end of 2017, well, you're kind of right back there, with these recent losses factored in. Remember that. Dialing it back even further, over the past 30 years, we've had extraordinarily strong returns from both stocks and bonds, remember that as well. That you've had this great tailwind and your portfolio is still probably in pretty good shape. Thanks to some of those forces.
Glaser: The second to-do though is really to dive into your portfolio, check your asset allocation, and make sure that is where you want it to be.
Benz: Right. I always say if someone's, say, under 50, don't get too caught up in terms of checking up on your portfolio's asset allocation. But it's truly important when you're retired or getting close to retirement and planning to actively draw upon your portfolio, to periodically assess your portfolio's asset allocation. If you're spending from your portfolio, as you know I'm a big believer in the bucket strategy for retirement, asset allocation, so if you're spending from your portfolio, use your portfolio withdrawals to guide how much to hold in those safe asset classes.
In my model bucket portfolios, I've typically carved out two years' worth of portfolio spending in cash instruments. Another three to eight or three to 10 years' worth of portfolio spending in high-quality bonds. If you haven't revisited your portfolio's asset allocation recently and you're getting close to retirement or already retired, do it now. If you've been very hands off and say you had a 60% equity, 40% bond portfolio in 2009, well, you're 85%, 15% bonds right now. You probably are more aggressive than you want to be.
Glaser: That leads into the third to-do, which is to check up on those liquid reserves and your high-quality bonds sleeve and make sure that they really are liquid and high quality.
Benz: Right. Really poke at that high-quality bond piece or the bond piece in your portfolio. We've seen much better returns, much better yields from some of the lower quality stuff recently. High-yield bonds, emerging-markets bonds, make sure that that isn't the complexion of your fixed-income portfolio. If you're looking for something to be true ballast for your equity holdings, you want it to be high quality. You probably don't want to be taking a lot of interest-rate risk at this juncture. It doesn't mean you want to be entirely short term, but you probably want to be primarily short- and intermediate-term with your bond portfolio and high-quality is key.
Glaser: One of the things retirees and everyone may have noticed is that both bonds and stocks have sold off recently. Is that a case against using bonds for diversification, or is that more of a short-term blip?
Benz: Yeah, it's been a little peculiar, I would say. It's probably troubling to people who have said "Well, I've followed the advice to hold high-quality bonds, and here they go. They've been going down right along with stocks." On that front, I would say a couple of things. One is that even though high-quality bonds have indeed gone down, the magnitude of their losses has been much less than stocks. That's a persistent pattern that we see over market cycles. I would bear that in mind.
Secondly, I would bear in mind that over the very long term we typically do see high-quality bonds hold up relatively well in equity market shocks. I don't see any big reason to suspect that that pattern will be different. Focus on the long view versus the losses that we've experienced in high-quality bonds on the very short-term basis.
Glaser: Your fourth to-do is to take a look at your spending rate and make sure that that is also where you want it to be.
Benz: Right. As we've all seen, our portfolios become enlarged, it's been easy to get a little bit complacent about our spending. We've all felt that wealth effect, as our portfolios have enlarged. But one of the key things retirees can do to make a save when their portfolios are declining is to rein in their spending a little bit. In fact, a lot of the great research about withdrawal rates has come back to that conclusion. If you can be a little bit market sensitive, that can go a long way toward improving your portfolio sustainability over your retirement time horizon. That's not to say that you should radically cut your spending--stop going to the movies or going out to dinner. But it does mean that you should be willing to rein it in a little bit if what we've started to experience in terms of market volatility proves to be something more persistent.
Glaser: And finally, it's worth it to take a look at your portfolio and sweat the small stuff.
Benz: Absolutely. Also in the realm of stuff that you can control as a retiree, on the short list would be things like looking at your cash holdings and what they're yielding. If you haven't revisited that lately, one thing we've seen is that cash yields have popped up pretty nicely. If you've been not paying attention, you maybe are stuck in some low yielding stuff, you could do better. Watch your investment related expenses. That's one of the best ways that I know of to improve take home returns. That's fund expense ratios, any advisory fees that you're paying, any other investment related costs. See if you can't trim them.
Finally tax costs are another big area that retirees can exert some level of control over. Most retirees are pulling their assets from multiple pools of money, whether taxable assets, Roth, or tax-deferred assets. If you're not super savvy on tax matters, work with a tax advisor to strategize about where best to pull your money from on a year-to-year basis in order to improve your take-home aftertax returns.
Glaser: Christine, thank you as always.
Benz: Thank you, Jeremy.
Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for watching.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Mihir Worah. He's the CIO of asset allocation and real return and also a managing director at PIMCO.
Mihir, thanks so much for joining me today.
Mihir Worah: It's a pleasure, Jeremy.
Glaser: I wanted to start by talking about inflation, a topic that's obviously been top of mind for the market in this last week or so. Do you think that the threat of inflation is real now? Should we be worried about price levels rising?
Worah: I think price levels are going up. They have been moving up and whether they keep moving beyond central bank targets and how central banks respond to them is a big worry for markets right now. We expect core inflation, in the U.S., is running at around 1.7% year over year. We think by the end of 2018, the base case is it should get to around 2.2%, which is right around the Fed's target. I think what the market's worried about is with inflation finally moving up toward the central bank's target, at the same time, you're getting this big fiscal boost. We're starting to see some signs of wages going up. We're starting to see inflation go up and at the same time, you've got the big $1.5 trillion tax cut that's over 10 years and now we're just hearing of the budget deal, which adds about another $100 billion, $150 billion per year to the deficit for the next couple of years. People are concerned about what this will do at a time when inflation is already starting to move up.
Glaser: What are your expectations of how aggressively central banks globally would react to this?
Worah: I think central banks are already on the move as they see economies healing and no need for the emergency measures that we had in place for so many years post-crisis. We know the Fed has already hiked five times and expectations are for another three hikes this year. The Bank of England, just today, started guiding toward perhaps an earlier hike and a repricing of hiking expectations. Economies are healing. Central banks are taking away emergency levels of liquidity. I think at the first stage, central banks have told us that they will accommodate, they do want inflation to go higher and in fact, the Fed has hinted several times that a little bit of an overshoot of inflation above its target wouldn't affect it.
I don't think central banks react very aggressively to inflation moving toward target and maybe slightly above target, but at the same time, that's the worry for markets. If central banks accommodate this rising inflation, perhaps we get an overshoot and we have to come down aggressively later on. In 2018, I don't think central banks react aggressively. We still get the three hikes from the Fed, maybe four. The concern is further out, we're getting late in the business cycle and what central banks do in 2019 and 2020 is getting to be a concern.
Glaser: You talked about rate hikes there. What about the balance sheet normalization of the Fed. Do you think that's having a big impact on the market?
Worah: That's having an impact on the market right now. I think what the market's focused on, rightly, is frankly neither so much the rate hikes or the balance sheet reduction. It's the combination of those with the huge fiscal deficits that we see coming down the pipe. The central bank's going to buy, the Fed's going to buy $200 billion less of Treasuries than it did last year. At the same time, the U.S. Treasury is going to issue $400 billion or $500 billion more of U.S. Treasuries. What the market's going through right now is with all of this excess supply, what is the clearing level? What are the yields where demand equals supply? The market's concerned about the Fed, but it's exacerbated by the fact that we're significantly increasing our fiscal deficits and Treasury supply.
Glaser: Let's look at what this could mean for investors. On the inflation front, does it make sense to have an allocation to an explicit inflation protection, something like TIPS, or do those look expensive today?
Worah: No. I think an explicit allocation either to TIPS or even to commodities makes sense today. TIPS are pricing about 2.1% per year for the next 10 years, which, given our base case and the risks to the upside, looks fairly attractive. It's not as attractive as three months ago when the market was pricing 1.9%, 1.8% per year for the next 10 years, but they're still attractive, especially as in the Treasury market, TIPS, at the end of the day, are U.S. Treasuries, full faith and credit. In the Treasury market, there's going to be a bit of a supply-demand imbalance in favor of TIPS. We told you, the Treasury's told us, we expect supply to go up by $400 billion or $500 billion this year relative to last year and as of now, none of that increase is going to be in TIPS for the next several months.
Sure, as Treasury supply goes up and fiscal deficits are here, TIPS supply is going to go up too, but for the next six months or so, all of the extra supply is going to be in regular, nominal Treasuries and none of that in TIPS. You've got something favoring TIPS. Then commodities, we know historically commodities do well in the late stages of an expansion as supply bottlenecks fail to keep up with demand growth. Moreover, the crude oil curve is in backwardation right now, so if nothing changes, you'll make 8% to 10% per year just owning crude oil futures. Both TIPS and commodities seem to be attractive investments right now.
Glaser: Looking at the diversification benefits of those nominal bonds, we saw this last week that bonds and stocks were kind of trading together. Is that, you think, a sign that we might not see the diversification benefits, or is there still a case to hold those long-term government bonds?
Worah: No. There's a strong case to hold long-term government bonds. I do caution that some of the correlations and historical relationships that we've seen over the last few years and that lots of people depend on may not be as reliable over short-term horizons, but if there's an event, if there's a recession, if there's a hit to equity earnings, if there's a geopolitical event and stocks are going down, for sure, bonds will be going up at that time. The defensive diversification benefits of Treasuries and government bonds isn't diminished. As a tail risk hedge, on the tails, when you get an event, when you get a bad event for something that's bad for the economy, bonds will do well and stocks will do poorly, so there's no change to that.
It's around the middle of the distribution, like I said, where volatility's going up and central banks are buying less bonds, yields are slowing rising, in this slowly rising yield environment, it starts hurting the discount factor and hurting valuations on equities. To put it, again, in a normal environment, if bond yields go up, you could see stocks going down at the same time as bond yields go up. But in the big picture, the defensive risk of hedge, bonds haven't lost their value at all.
Glaser: And finally, I did want to touch briefly here on equities and where you see the stock market today. With some of the volatility we've seen and a little bit of a sell-off here, where do you see valuations?
Worah: Valuations, where we are for the S&P, 2650, the forward P/E's obviously come down compared to its peak at 2850, so in 2018, 2019, P/Es are around 17 or 18, I think that's reasonable. The stock market is reasonably priced, it's just that we need to work through this volatility of either people overpositioned in the stock market, people expecting low volatility forever, this volatility around finding a new clearing yield, for bonds, given all the excess supply we're going to see--we need to work through all of these issues, which should work to some medium-term volatility, but for long-term investors, 2650 on the S&P, I think it's a fine level to be invested.
Glaser: Mihir, I really appreciate you taking the time today.
Worah: Thanks a lot, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Liz Ann Sonders, she's the chief investment strategist at Charles Schwab. We're going to talk a little bit about what's been happening over the last couple of days.
Liz Ann, we really appreciate you taking the time today.
Liz Ann Sonders: Thanks for having me.
Glaser: Let's start by just putting what happened on Monday and also last week into context. There's been some scary headlines out there, but historically, is this really all that bad?
Sonders: I actually think many of the headlines were a bit irresponsible and certainly hyperbolic with "largest decline for the Dow in history." Yes, that is actually true from a point perspective, but it barely makes it in the top 100 on a percentage basis in the S&P 500, which is arguably a better index. It was the 138th worst single day decline. I think a little context is important. Not to suggest that this isn't painful, but I think the headlines were a bit hyperbolic.
Glaser: Let's look at potentially what was driving some of these moves. The conventional wisdom is that it was about potentially interest rates going higher. Does that ring true to you, or do you think this was more of a valuation-driven event?
Sonders: I don't think it was so much valuation-driven. I think fundamentals did drive the early part of this. The more economic fundamentals would be the spike we saw in wage growth to 2.9% for average hourly earnings on a year-over-year basis. That caused a spike up in the 10-year Treasury yield, broke through 2.8% on the upside, inflation expectations kicking in. I think was the more economically driven kicker.
But then I think the other kicker was less technical, but more sentiment-based. Because of how low the volatility was last year, 3% maximum draw down, second-lowest year of volatility on that metric in history, and if you look back on years past when you've had really, really low drama years, they tend to be followed by high drama years, even if you ultimately still have decent returns. With that low drama year last year and strong returns, enthusiasm kind of just went off the charts. Most attitudinal measures of sentiment got to all-time high record levels of optimism. I just don't think you had a lot of room for error.
But then as the sell-off worsened, and in particular what happened yesterday was less about the magnitude of the decline in percentage or point terms, and more about the spike in volatility. That spike in the VIX triggered a lot of forced selling of some of these positions tied to low volatility. It was a market-structure thing more than anything else.
Glaser: When you look at the fundamentals of the economy, do you see anything that shows that there is potentially some trouble on the horizon? Or will this be more of an isolated kind of structural market event?
Sonders: We did see a change in the characteristic this year with that pickup in wage growth, the rising inflation expectations, the expectations for tighter monetary policy, the likelihood of an uptick from what has been record low levels of financial stress. The financial conditions, even though the Fed has been raising interest rates for two plus years, financial conditions have never been as easy as they have been until recently. The stock market is a feeder into that, so I would expect to see financial conditions worsen a little bit here.
It's been our view that the flavor of the background fundamental environment was changing this year. We're later in the cycle, that means higher inflation, tighter monetary policy. That adds to volatility, puts some downward pressure on valuation. I do think there has been a fundamental shift.
What I don't think this represents is the beginning of the end for the bull market, i.e., I think the next true bear market will be one that is more traditional in nature and comes when the market starts to sniff out the next recession. I don't think that's in the near term cards. But, we may have more technical damage to come.
Glaser: Looking at that potential for tighter monetary policy, as Powell takes over the reins of the Fed, what do you think is going to happen with rates in 2018?
Sonders: We've had the view that three rate hikes is the base case for this year. I don't know that I would suggest we're changing our view as a function of this. Now, in the immediate aftermath of last Friday's jobs report when we saw that higher wage number, you did see a quick spike in expectations for maybe four rate hikes this year, and I think that that was a little bit of a spook factor for the market. Since that time actually, though, we've seen a ratcheting down of those expectations. In fact, the Fed fund futures market now doesn't even really have three as the base case. A lot can happen. Even between now and the March meeting, let alone the rest of this year. I think trying to game exactly how many rate hikes would happen is a bit of a silly exercise at this point, because it is data-dependent, but also to some degree, probably a function of market volatility to a lesser degree anyway. I think that a faster pace of rate increases is in the cards.
It's not just rate increases. The Fed is trading its balance sheet right now too, so we have another form of tightening in the form of quantitative tightening. I think the liquidity coming out that is represented by that, I think that's a fact that is not getting maybe the attention that it deserves.
Glaser: Liz Ann, we really appreciate you taking the time and sharing your insights on the market today.
Sonders: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
Adam McCullough: Vanguard Dividend Appreciation ETF (VIG) and Vanguard High Dividend Yield ETF (VYM) are among the cheapest dividend-oriented funds available. VIG earns a Morningstar Analyst Rating of Gold while VYM earns a Morningstar Analyst Rating of Silver. The primary difference between the funds is that VIG targets dividend growth while VYM targets high-dividend yield.
VIG targets stocks that have raised dividend payments for at least 10 consecutive years and applies a profitability screen to avoid stocks that may be at risk of cutting their dividend payment. To further mitigate risk, VIG weights its holdings by their market capitalization and caps single stock weightings to 4% of the portfolio.
On the other hand, VYM targets the highest-yielding half of U.S. stocks. Like VIG, it market-cap-weights its holdings and reduces its risk by owning a broadly diversified portfolio. VYM holds about 400 names compared to VIG's 180 holdings.
As of Dec. 31, 2017, VYM’s dividend yield measured 3.0% compared to 1.9% for VIG. But don't be too put off by VIG's lower dividend yield. This fund earns a Morningstar Analyst Rating one notch above that of VYM because of its risk-mitigation approach.
For example, VIG dropped ConocoPhillips stock from its portfolio before ConocoPhillips cut its dividend payment in early 2016, presumably because it didn't pass VIG's profitability screen, while VYM still owned ConocoPhillips through its dividend cut. VIG's higher quality portfolio helped during the bear market from October 2007 to March 2009. VIG lost 46% over this time period while VYM experienced a 57% drawdown.
Both funds are excellent choices for investors seeking dividend-oriented strategies. Informed investors will understand that the primary difference between both funds is how they balance the trade-off between dividend yield and risk.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The energy sector has been hit particularly hard during the sell-off. I'm here with David Meats, who's a senior equity analyst, for his take on why that could be happening.
David, thanks for joining me.
David Meats: Of course.
Glaser: It's impossible to ever point to one particular issue of what's driving an entire sector, but what do you think some of the factors are behind this sell-off?
Meats: It was a pretty strong rally in oil prices in the last six months. WTI went from probably $45 to $65 since June of last year, and I think there's really a false sense of security in oil markets caused by the OPEC production cuts and by the disappointing growth from U.S. shale last year. U.S. shale last year was expected to grow much more robustly than it actually did. Volumes were stagnated during the middle of the year, and I think that with the most recent data suggesting that that surge is finally coming, that gives investors the realization that maybe the current tightness in oil markets is more temporary than they're perhaps thinking.
Glaser: One of the big drivers really is just that the price of oil is falling here, or could be?
Meats: Essentially, you had a lot of issues in oil markets recently. There is potential for further sanctions on Iran which were waived in January, but you have the 120 day window. Maybe that's something that gets revisited later in the year. And you have a huge output decline in Venezuela, which is very positive for oil prices, but I think that investors are really assuming the worst case scenario for production this year, so on the supply side, and that actually sets us up for some potential oversupply in the back half of the year. I think it's definitely oil price-focused. I think that the rally that we did see in the last six months was not really justified, and I think that we're seeing a correction to adjust for that.
Glaser: Let's take a look at where that leaves us in terms of valuations. Even after the sell-off, are you seeing value across energy? Are there places that look more attractive, less attractive?
Meats: I think there are pockets of value. Obviously, stocks are correlated with energy prices, so a bearish outlook like we have for oil prices is not great for sector valuations. But in certain particular cases, there are opportunities. I would point to the shale focused companies at the very bottom of the cost curve that can still thrive in an environment with proof prices in the $50 or $55 a barrel range.
In particular, we like RSP Permian and Diamondback Energy. Both of those companies have very high quality acreage. We call it "Tier 1," right in the core of the play where the well productivity is the highest, which gives you the best bang for the buck in terms of the returns. We like the shale focused companies at the bottom of the cost curve, and I would also point to the midstream industry just because it's not levered to oil prices because the contracts are fee based.
We would again, as we favor the Permian Basin as the main growth engine for shale, I would point to Enterprise Product Partners and Plains All American Pipeline, those companies that are positioned to capitalize on that Permian growth.
Glaser: David, thanks for the update on energy today and for those ideas.
Meats: You bet.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.