Inflation

Inflation

An Evidence-based guide to investing

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What’s the point of investing, anyway? We invest our money for future consumption, with the idea that we’ll earn a higher rate of return from investing in a portfolio of stocks and bonds than we will from holding cash.

But where does this equity premium come from? And how do we capture it without taking on more risk than is needed? Moreover, how do we control our natural instincts of fear, greed, and regret so that we can stay invested long enough to achieve our expected rate of return?

For decades, regular investors have put their trust in the expertise of stockbrokers and advisors to build a portfolio of stocks and bonds. In the 1990s, mutual funds became the investment vehicle of choice to build a portfolio. Both of these approaches were expensive and relied on active management to select investments and time the market.

At the same time, a growing body of evidence suggested that stock markets were largely efficient, with all of the known information for stocks already reflected in their prices. Since markets collect the knowledge of all investors around the world, it’s difficult for any one investor to have an advantage over the rest.

The evidence also showed how risk and return are intertwined. In most cases, the greater the risk, the higher the reward (over the long-term). This is the essence of the equity-risk premium – the excess return earned from investing in stocks over a “risk-free” rate (treasury bills).

Evidence-based investing also highlights the benefit of diversification. Since it’s nearly impossible to predict which asset class will outperform in the short-term, investors should diversify across all asset classes and regions to reduce risk and increase long-term returns.

As low-cost investing alternatives emerged, such as exchange-traded funds (ETFs) that passively track the market, the evidence shows that fees play a significant role in determining future outcomes. Further evidence shows that fees are the best predictor of future returns, with the lowest fees leading to the highest returns over the long term.

Finally, it’s impossible to correctly and consistently predict the short-term ups and downs of the market. Stock markets can be volatile in the short term but have a long history of increasing in value over time. The evidence shows staying invested, even during market downturns, leads to the best long-term investment outcomes.

Evidence-based Guide to Investing

So, what factors impact successful investing outcomes? This evidence based investing guide will reinforce the concepts discussed above, while addressing the real-life burning questions that investors face throughout their investing journey.

Questions like, should you passively accept market returns or take a more active role with your investments, should you invest a lump sum immediately or dollar cost average over time, should you invest when markets are at all-time highs, should you use leverage to invest, and how much home country bias is enough?

To answer these questions, I looked at the latest research on investing and what variables or factors can impact successful outcomes. Here’s what I found:

Passive vs. Active Investing

The thought of investing often evokes images of the world’s greatest investors, such as Warren Buffett, Benjamin Graham, Peter Lynch, and Ray Dalio: skilled money managers who used their expertise to beat the stock market and make themselves and their clients extraordinarily wealthy.

But one man who arguably did more for regular investors than anyone else is the late Jack Bogle, who founded the Vanguard Group. He pioneered the first index fund, and championed low-cost passive investing decades before it became mainstream.

Jack Bogle’s investing philosophy was to capture market returns by investing in low-cost, broadly diversified, passively-managed index funds.

“Passive investing” is based on the efficient market hypothesis: that share prices reflect all known information. Stocks always trade at their fair market value, making it difficult for any one investor to gain an edge over the collective market.

Passive investors accept this theory and attempt to capture the returns of all stocks by owning them “passively” through an index-tracking mutual fund or ETF. This approach avoids trying to pick winning stocks, and instead owns the market as a whole in order to collect the equity risk premium.

The equity risk premium explains how investors are rewarded for taking on higher risk. More specifically, it’s the difference between the expected returns earned by investors when they invest in the stock market over an investment with zero risk, like government bonds.

Bogle’s first index fund – the Vanguard 500 – was founded in 1976. At the time, Bogle was almost laughed out of business, but nearly 50 years later, Vanguard is one of the largest and most respected investment firms in the world. Who’s laughing now?

In contrast, opponents of the efficient market hypothesis believe it is possible to beat the market and that share prices are not always representative of their fair market value. Active investors believe they can exploit these price anomalies, which can be observed when trends or momentum send certain stocks well above or below their fundamental value. Think of the tech bubble in the late 1990s when obscure internet stocks soared in value, or the 2008 great financial crisis when bank stocks got obliterated.

Comparing passive vs. active investing

Spoiler alert: there is considerable academic and empirical evidence spanning 70 years to support the theory that passive investing outperforms active investing.

The origins of passive investing dates back to the 1950s when economist Harry Markowitz developed Modern Portfolio Theory. Markowitz argued that it’s possible for investors to design a portfolio that maximizes returns by taking an optimal amount of risk. By holding many securities and asset classes, investors could diversify away any risk associated with individual securities. Modern Portfolio Theory first introduced the concept of risk-adjusted returns.

In the 1960s, Eugene Fama developed the Efficient Market Hypothesis, which argued that investors cannot beat the market over the long run because stock prices reflect all available information, and no one has a competitive information advantage. Continue Reading…

Noah Solomon: The Times they are A-Changin’

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Shutterstock/ Photo Contributuor PHLD Luca.

Come gather ’round people
Wherever you roam
And admit that the waters
Around you have grown
And accept it that soon
You’ll be drenched to the bone
If your time to you is worth savin’
And you better start swimmin’
Or you’ll sink like a stone
For the times they are a-changin’

  • Bob Dylan © Sony/ATV Music Publishing LLC

By Noah Solomon

Special to Financial Independence Hub

In this month’s commentary, I will discuss both how and why the environment going forward will differ markedly from the one to which investors have grown accustomed. Importantly, I will explain the repercussions of this shift and the related implications for investment portfolios.

The Rear View Mirror: Where we’ve been

After being appointed Fed Chairman in 1979, Paul Volcker embarked on a vicious campaign to break the back of inflation, raising rates as high as 20%. His steely resolve ushered in a prolonged era of low inflation, declining rates, and the favourable investment environment that prevailed over the next four decades.

Importantly, there have been other forces at work that abetted this disinflationary, ultra-low-rate backdrop. In particular, the influence of China’s rapid industrialization and growth cannot be underestimated. Specifically, the integration of hundreds of millions of participants into the global pool of labour represents a colossally positive supply side shock that served to keep inflation at previously unthinkably well-tamed levels in the face of record low rates.

It’s all about Rates

The long-term effects of low inflation and declining rates on asset prices cannot be understated. According to Buffett:

“Interest rates power everything in the economic universe. They are like gravity in valuations. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on values.”

On the earnings front, low rates make it easier for consumers to borrow money for purchases, thereby increasing companies’ sales volumes and revenues. They also enhance companies’ profitability by lowering their cost of capital and making it easier for them to invest in facilities, equipment, and inventory. Lastly, higher asset prices create a virtuous cycle: they cause a wealth effect where people feel richer and more willing to spend, thereby further spurring company profits and even higher asset prices.

Declining rates also exert a huge influence on valuations. The fair value of a company can be determined by calculating the present value of its future cash flows. As such, lower rates result in higher multiples, from elevated P/E ratios on stocks to higher multiples on operating income from real estate assets, etc.

The effects of the one-two punch of higher earnings and higher valuations unleashed by decades of falling rates cannot be overestimated. Stocks had an incredible four decade run, with the S&P 500 Index rising from a low of 102 in August 1982 to 4,796 by the beginning of 2022, producing a compound annual return of 10.3%. For private equity and other levered strategies, the macroeconomic backdrop has been particularly hospitable, resulting in windfall profits.

From Good to Great: The Special Case of Long-Duration Growth Assets

While low inflation and rates have been favourable for asset prices generally, they have provided rocket fuel for long-duration growth assets.

The anticipated future profits of growth stocks dwarf their current earnings. As such, investors in these companies must wait longer to receive future cash flows than those who purchase value stocks, whose profits are not nearly as back-end loaded.

All else being equal, growth companies become more attractive relative to value stocks when rates are low because the opportunity cost of not having capital parked in safe assets such as cash or high-quality bonds is low. Conversely, growth companies become less enticing vs. value stocks in higher rate regimes.

Example: The Effect of Higher Interest Rates on Value vs. Growth Companies

The earnings of the value company are the same every year. In contrast, those of the growth company are smaller at first and then increase over time.

  • With rates at 2%, the present value of both companies’ earnings over the next 10 years is identical at $89.83.
  • With rates at 5%, the present value of the value company’s earnings decreases to $69.91 while those of the growth company declines to $64.14.
  • With no change in the earnings of either company, an increase in rates from 2% to 5% causes the present value of the value company’s earnings to exceed that of its growth counterpart by 9%.

Losing an Illusion makes you Wiser than Finding a Truth

There are several features of the global landscape that will make it challenging for inflation to be as well-behaved as it has been in decades past. Rather, there are several reasons to suspect that inflation may normalize in the 3%-4% range and remain there for several years.

  • In response to rising geopolitical tensions and protectionism, many companies are investing in reshoring and nearshoring. This will exert upward pressure on costs, or at least stymie the forces that were central to the disinflationary trend of the past several decades.
  • The unfolding transition to more sustainable sources of energy has and will continue to stoke increased demand for green metals such as copper and other commodities.
  • ESG investing and the dearth of commodities-related capital expenditures over the past several years will constrain supply growth for the foreseeable future. The resulting supply crunch meets demand boom is likely to cause an acute shortage of natural resources, thereby exerting upward pressure on prices and inflation.
  • The world’s population has increased by approximately one billion since the global financial crisis. In India, there are roughly one billion people who do not have air conditioning. Roughly the same number of people in China do not have a car. As these countries continue to develop, their changing consumption patterns will stoke demand for natural resources, thereby exerting upward pressure on prices.
  • Labour unrest and strikes are on the rise. This trend will further contribute to upward pressure on wages and prices.

A Word about Debt

The U.S. government is amassing debt at an unsustainable rate, with spending up 10% on a year-over-year basis and a deficit running near $2 trillion. Following years of unsustainable debt growth (with no clear end in sight), the U.S. is either near or at the point where there are only four ways out of its debt trap:

  1. Raise taxes
  2. Cut spending/entitlements
  3. Default
  4. Stealth default (see below) Continue Reading…

Big tax tips for small business owners

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Image by Pexels: N. Voitkevich

By Aurèle Courcelles, CFP, CPA

Special to Financial Independence Hub

Small businesses play a sizeable role in shaping Canada’s economy, contributing significantly to national employment numbers and our country’s gross domestic product (GDP).

According to Statistics Canada, in 2022 businesses with 1 to 99 employees made up 98 per cent of all employer businesses in this country. But today’s economic environment has triggered new financial challenges for this cohort. Canadian entrepreneurs can help offset the cost of rising inflation, rising cost of inputs, and rising interest rates, and keep more money in their pockets, by adopting some or all of these key tax strategies.

Consider employing your immediate family

Income splitting, whereby the higher-earner transfers part of their income to a lower-earning family member, can reduce the tax owed by your household. Consider paying a reasonable salary to your spouse and/or children for the services they provide for your business to reduce your tax obligations.

Incorporate your business

If your business generates more profit than you need to live on, incorporation is a highly effective tax strategy. It could lead to a significant tax deferral by qualifying for the lower small business tax rate for active income – the longer the profits are left in the company, the larger the tax deferral. If shares of the business are ultimately sold and are eligible for the lifetime capital gains exemption, the tax deferral gained through incorporation can create a permanent tax saving.

Other potential advantages of incorporation include having family members own shares (so as to have access to multiple capital gains exemptions) and possibly paying out dividends to actively participating family members who are taxed at a lower rate.

Maximize tax breaks with registered plans

Consider your RRSP contribution room when setting and reporting remuneration for services provided by yourself and family members who also work in the business. Employment income creates RRSP contribution room for the following year which, for 2024, can represent up to $31,560 of room. RRSP contributions are tax deductible, provide tax deferral and allow for business owners to diversify their future retirement income.  Contributing to a tax-free savings account (TFSA) can also work in your favor by allowing you to withdraw funds if needed without penalty. Continue Reading…

Franklin Templeton mid-year outlook: Caution lights on Recession

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Jeffrey Schulze

The 12 variables used to forecast Recessions are currently “signalling caution,” says Jeffrey Schulze, CFA.

Speaking Wednesday in Toronto at Franklin Templeton’s mid-year outlook, Schulze — Managing Director, Head of Economic and Market Strategy for Clearbridge Investments — told financial advisors and media that as of May 2024,  the 12 variables he tracks have “historically foreshadowed a looming recession … the overall dashboard [shown below] is currently signalling caution.”

 

Three indicators — Job Sentiment, Money Supply and Yield Curve — have been flashing red since the end of 2023 and continue to be, as you can see in the above chart taken from a presentation made available to attendees. The only green light is Credit Spreads, while the other eight — which include Housing Permits, Jobless Claims and Profit Margins — are all a cautionary yellow.

However, stock valuations do not appear to be too stretched at present. The composition of major stock indexes, such as the S&P500, support higher P/E ratios, Schulze said. “Less-volatile defensive and growthier sectors are typically rewarded with higher multiples. These groups make up a near-record share of the S&P 500 today.” As you can see in the chart below and in the higher purple line of the graph, these Defensive stocks include Tech, Consumer Staples, Utilities, and Health Care.

However, Schulze did note a “troubling” record-high concentration of the largest S&P500 names by market weight. As you can see in the chart below, the five largest-cap components now account for more than a quarter (25.3%) of the index, which is “the highest levels in recent history … While this dynamic can persist, history suggests that a reversion to the mean will eventually occur with the average stock outperforming in the coming years.”

 

In fact, the combined weight of the so-called Magnificent 7 tech stocks now exceeds the combined market weight of the stock markets of Japan, the U.K., Canada, France, and China!

 

However, “after behaving fairly monolithically in 2023, the performance of the Mag 7 members have diverged substantially so far in 2024,” Schulze said. A slide of the “Divergent 7”  showed Tesla down 28.3% and Apple flat, while the others were higher, led by the 121.4% surge in the price of Nvidia this year.

A key driver of the Mag 7 outperformance has been superior earnings growth, Schulze said, but “this advantage is expected to dissipate in the coming year,  which could be the catalyst for a sustained leadership rotation.”

Companies that grow their dividends are overdue to start outperforming. “Over the past year, dividend growers have trailed the broader market to a degree rarely seen over the past three decades … Past instances of similar underperformance have been followed with a strong bounce-back for dividend growers.”

A positive for markets is the “copious” amount of cash sitting on the sidelines and being readied to deploy on buying stocks. After the October 2022 lows, investors flocked into money market funds with a net increase of US$1.5 trillion, or 32%, Schulze said:  “Should the Fed embark upon its widely anticipated cutting cycle later this year, investors may reallocate. This represents a potential source of upside for equities.” Continue Reading…

Stocks still marching to inflation’s drum

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By Elias Barbour, Clearbridge Investments

(Sponsor Blog)

Inflation continues to be the biggest near-term driver for equity markets, given its influence on central bank decision-making regarding interest rates. Inflation rates have moderated from their peak levels; however, they remain above the 2% targets set by the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed).

U.S. and Canada Inflation

As of April 30, 2024

 

 

Equity markets entered 2024 with six to seven U.S. interest rate cuts priced in over the course of 2024, with the first cut expected in March. Clearly, that did not happen. Both central banks have remained on hold, which has contributed to higher rates across the yield curve. That number has since moderated to only three cuts, and the timing of the first cut has now been pushed out to June in Canada and even later in the United States.

The effect of “higher for longer” interest rates has been particularly painful for interest rate-sensitive market sectors such as utilities and communication services. Nonetheless, pockets of the market that were expected to continue to grow have continued to advance, undeterred by the yield curve shifts.

Buoyed by hopes for a pivot in monetary policy as inflation trended closer towards the central banks’ targets, Canadian equities had a strong start to the year, although they paled compared to the ongoing boom in U.S. equities, where a large portion of the gains were derived from mega-cap information technology  and related names with less representation in Canadian markets.

Mind the lag

Although decelerating, the economy continues to show sufficient resilience, with customer spending remaining robust since the reopening of economies after the global pandemic-induced shutdowns. Fiscal stimulus has moderated since the immediate aftermath of the pandemic outbreak; however, fiscal policy continues to operate at odds with monetary policy. Labour strength and wage gains have further reinforced this view, fuelling fears of lingering inflation and the potential for a higher-for-longer rate environment. Continue Reading…