Inflation, Interest Rates & Investing into 2024—featuring Brandon Hobson & Paul Lipcius

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Welcome back everybody to another episode of the Dental Boardroom podcast. I'm very excited we have a new guest joining us for our quarterly investment podcast series. He is my friend, colleague and partner, Mr. Paul Lipschiss. And back again on the show we have our Chief Investment Officer, portfolio designer, and lead investment committee member, Brandon Hofstadt. We have some great topics to cover today that I'm very excited to share with you all. There has been a lot of changes that have happened in the market since our last quarterly podcast on these topics and so we're going to do a little bit of a recap from last time and catch you guys up on what has changed and then open up the discussion to some new ideas and some new things that have emerged since our last time together. With that said, we will start with inflation as it's been still a hot topic in the Federal Reserve and their more recent updates as it relates to inflation and interest rates. So so we'll start off with Brandon leading the charge on this topic and then Paul and myself will jump in as we can or as needed.

Awesome. Thanks, Drew. I appreciate the intro. For everyone who's tuned into the last few podcasts that we've done, we typically kick it off with a Federal Reserve overview or briefing, if you will. We'll start there again today. Overall CPI came in at 3.2%. That's a huge improvement, obviously from what we've been seeing over the last year and a half where at some points inflation was running double digits. That's where you're starting to hear some talks of the Fed pausing their rate hiking campaign. The board members are actually starting to come out and comment a little bit to reassure markets that they might be done hiking for the rest of this year. They haven't gone as far as to say that they're done hiking this cycle. I think. Actually the Fed chair Jerome Powell came out the other day and said that any talks of cuts or pausing hikes at this point would be premature. But nonetheless, inflation is falling back in line with the overall Fed target, which is 2%. That's where the Fed would like to see inflation on a long run basis. This last 1% could prove to be very difficult, obviously to get down to 2%. They call that stubborn inflation, where we could be sitting at 3% next year, meaning not 2024 but early 2025. We could be still sitting at around 3%, but we won't know until the data rolls in and some of these Fed rate hikes take hold, which have already been put into place over the last six months or so. They have to work their way through. Not quite there yet. Paul, what's your take on the Fed there and how they might proceed?

Well, I think the big thing for people to keep in mind is I think Jerome Powell was very clear that they haven't made a decision. But the markets are clearly pricing in a pause and in many corners expecting cuts early next year. My personal opinion is I believe them. I take him at his word that one of the main takeaways I had was they would rather err on the side of the tightening or loosening too late than going too early to it and being stuck with stubborn inflation. My take on it is really a mixed bag. I think right now. Brandon, you might agree with me the market's, I would say, a little overly optimistic. What are your thoughts on that? The way that the bond market and the stock market have been pricing in the Fed's next moves?

Agreed. I think a lot of good news is priced in and I think that that's probably going to continue throughout the rest of this month or December, if history is any indication. December tends to be, I think, the best month for the stock market in general over the long run. I wouldn't be surprised if this strength continues. But I agree with you in that we're pricing in a Goldilocks scenario here and that being a soft landing with probably not too much higher unemployment, which is where we're at now, right around 3.9%. And this soft landing scenario where we don't drive ourselves into a recession and companies are able to grow earnings high single digits, possibly double digits next year, which could happen. But to your point, I think, Paul, is that we're not leaving ourselves a whole lot of room for error in the way that the market's rallied at this point. It's kind of pricing in that Goldilocks scenario. Anything that is not necessarily going to be in that scenario is probably going to result in a negative response early next year.

Yeah, I agree. I'm always invested. I want my clients to be the same. But this rally that we've had in November, it just feels like that Goldilocks scenario is completely fixated, front center in everyone's mind. You're also seeing in sector performance, right, with a pretty sticky, a pretty tight monetary backdrop. We're not seeing the usual sectors we'd expect to see outperforming in this particular rally. We're seeing tech and cyclicals and some of those sensitive sectors really lead the way, which has you scratch your head A little bit. What are your thoughts on that? Where do you see us? How do you characterize that rally in risk on sectors of the market? And where do you think we're headed next?

Yeah, it's a good question. It's interesting because I think small caps have been beaten up so badly. It's kind of like the opposite of the Goldilocks scenario that we were talking about with the broader market index, which is primarily being driven by the magnificent seven stocks. So essentially seven stocks are responsible for over 50% of the S&P's performance this year. I think the S and P is up about 19% year to date as of today. And if you strip out the Magnificent Seven stocks, those big stocks including Nvidia, Tesla, Alphabet, Microsoft, Apple, if you strip them out, we're only at about 8% year to date gain. That just goes to show you that the largest stocks are those Magnificent Seven that have been driving the market performance. If they don't continue to perform the way that they have, we're probably going to see a pullback, at least in the overall broader indexes like the S and P and the Russell 3000. I do think that small caps have some room to run and also some of those smaller, not necessarily small cap stocks, but smaller than those Magnificent Seven stocks that have underperformed this year. So we could see a situation next year where the indexes necessarily aren't being reflective of what's happening under the hood, which this year is kind of the case as well. It seems like the indexes have performed great, but for anyone who has a diversified portfolio, those gains have not been reflected in your portfolio unless you've been heavily tilted towards those magnificent seven stocks. And most of us are not putting 30% of our portfolio there. Overall, I think only 30% of money managers are actually beating these broad indexes this year because, because of the fact that it's so bifurcated and actually the gains are being held within a small group of stocks that nobody really has as much exposure to relative to, say, the s and P500, which has 30% now in those magnificent seven. So hopefully value stocks continue to. We're starting to see that broadening out this month. It's only been about a week. So it can reverse and we've seen false starts and it reverses fairly quickly this year. But if we see this strength continue throughout the rest of December, then hopefully next year we'll see this broadening out where some of the smaller cap stocks, some of these value stocks that underperformed will start to pull some of the weight there. And the larger indexes aren't going to reflect it because those are still going to be driven by those big stocks that hopefully should pull back. There's only so many days and months and years that Apple, Microsoft and Tesla can continue to to outperform up 30, 40% year to date.

Yeah, I have two comments on that, one more so for our listeners and then one comment or opinion on that. The term that brand's referring to is breadth. Breadth is a measure of essentially how broad the performance of a basket of socks, or in this case the index S&P 500 is. Right now we have historically low breadth. Basically we've got few carrying the masses. That tends to be a somewhat of a bearish indicator for the overall index when very few are propping up the performance. Opinion time here is not as much scratch my head, but what has me on the cautious side of optimistic is how much of that performance is driven by valuations. Right. When a stock goes up, there's really two things that drive that. It's the performance, how much is it growing its earnings and then how much are investors willing to pay for that performance. And so when we look at PE ratios, price earning ratios and price of book value, price to sales, some of these traditional valuation metrics. Same way where you pay two and a half times earnings for dental practice, well, you're paying $18, $19 for every earnings for your S&P 500 on average. But for an Apple, you're paying 30. For Tesla, you're paying a 70. For Nvidia, you're paying 110, for example. And so these valuations have just become extremely detached and driven by a lot of hype narrative. And so I caution people to follow that trend. It's very attractive when you see 30, 40% returns and these companies seem too big to fail and that sort of thing. But the reality is that their valuations are so astronomically high they have to deliver and not only deliver on earnings expectations, they're going to have to beat lofty expectations to keep it going. I think it's a really good setup for the sort of forgotten sectors and the forgotten businesses. There's plenty of businesses out there trading at reasonable valuations, growing their earnings, reasonable debt loads. They've done well to take advantage of low rates when they're available and have structured maturities that their core businesses can handle even in tough times. And I think that's where people should be looking. I think that's where people should be looking in any market but in this backdrop, particular with a coin flip on monetary policy going forward and so much bloat and so little breadth in the performance of the index that there's a lot of value opportunities in the nooks and crannies. And Brandon, I know you and I are consistent on that. What are some of your favorite sectors on a go forward basis that you think, and without getting terribly technical, but just more basic overview of why those might be better performers in the future?

Yeah, yeah, that's a good question. I do like to focus on sectors primarily because you'll find that certain sectors tend to be undervalued. And that's kind of what I focus on as an investor is valuations, which you've indicated a little bit, are basically judged by price to earnings ratios, book values, things like that. The sectors that I really like now are sectors that aren't too sensitive to interest rates as well. So energy oil's at, it's actually trading at I think a 12 month or 11 month low right now. And there's a lot of negativity that's being priced in, in general to the energy sector. But if you look at some of the performance metrics on energy, it's some of the highest dividend payers in the energy sector, some of the lowest PE ratios. And the reality is, even if we do make this big move to a green transition, it's going to be more than 10 to 15 plus years. Even Warren Buffett's on record saying that it's going to be a long time before that actually happens. And so I think some of that negativity is being priced in today when the reality is the cash flows over the next 10 to 15 years are not going to be very heavily impacted by rotations into this new green energy sector. I also like industrials, given where we are on the economic backdrop and the fact that what appears to be happening in my opinion is that I'm not saying that we aren't going to hit a recession, but I'm pretty confident in saying that we're not going to hit a, a very hard recession or a very hard landing, if you will. So with that being said, industrials do tend to outperform in the early stages of a rally or expansion phase, which I think we'll be entering. Whether that's in the next three months or six months, I'm not too concerned because industrials on the value side are extremely low right now and I do think that their price of earnings and their valuations are attractive. I also like financials I also like.

Sorry. On industrials. I think industrials are easy to. It's one of the least sexy sectors. Just saying it makes you bored. But, but it's also got a, a lot of government money going into the sector, which I think is something to. No matter what side of the aisle you're on, it's something to consider. You know, infrastructure is always important. Right. And so that narrative can support long term growth just as much as an opportunistic valuation today. So I agree with you, especially on the industrial side. I think there's a ton of opportunity there.

Yeah. And I think when you look at value, just value oriented ETFs, you'll see, Paul, that they're kind of heavy in these sectors that we're talking about, which is energy. Most of them, energy only makes up I think 3 to 4% of the total S and P. And so if you're saying that your market weighting is in line with the s and P500, that would mean that you have probably somewhere around 3 to 4% exposure in energy. But if you look at some of these dividend paying ETFs and these value based ETFs, they're double that. So they're more around 9 to 10%.

And I would actually support that on the industrial side. They're not double the weight of industrials because industrials is already around 9 to 10% of the S and P. So it's a much larger sector in general, but they're still heavyweight. So they might be somewhere between 3% to 15% industrials as opposed to the market weight of 9 to 10. And then financials, which probably, if I just narrowed this, the three sectors that I would talk about in terms of valuations, the third would be financials. That's another really heavy sector in these value and dividend based ETFs. And as interest rates, specifically short term interest rates start to come down and long term interest rates go up, which that's peeled back a little bit over the last two weeks. But rates have been extremely volatile and very unpredictable. It's setting up fairly nicely right now where there's been a lot of negative news baked into banks in general with the failures that we saw over the last nine months or about nine months ago, we had a couple of big failures and some of that negative news has really impacted some of these very solid large mega cap type banks in the financial sector like JP Morgan, Morgan Stanley, Goldman Sachs. All these companies are trading at fairly low valuation, single digit P Es and their net Interest revenue, which is basically how much money they're making to lend money versus how much they have to pay to bring it in. As rates come down on the shorter end, they're going to have to pay less money to the depositors who deposit that money with their banks and they'll be able to lend it for a higher interest rate on the longer end of the curve for like mortgage loans and things like that. And that's where you're going to start to see financials outperform. We're starting to see that show up in the numbers today, but it's not going to show up into their financial reports for quarters possibly a year or more. So some of those things I think about now as ways that we could rotate into certain sectors to benefit some of our clients here would be value focused in financials, industrials and energy specifically. I also like materials for various reasons.

What about. I will say on financials too I think people have somewhat of a bias because obviously the last financial crash was caused by the banks and really problematic and it is very much stained on everyone's memory. But I will say that this environment, especially in the last 30 to 60 days has definitely improved their conditions. Bank failures. Brandon mentioned the main driver there being that they were holding these long term Treasuries, that their carrying value in the resale market was much lower than their face value. So that was problematic with a bank run and they have to go liquidate those Treasuries. But they bought at $100 a unit at 70, 80 cents on the dollar. We've seen a really strong rally in Treasuries the past month or so pretty much from the date of the last Fed meeting. And so that's really got to help shore up their balance sheet on that end. But I agree with you on the valuation side for them. Another sector I like that you didn't mention is healthcare simply because it's got a defensive narrative, but there's also segments in there that are really exciting and and growing in biotech space. And I think overall for a sector that is defensive by nature but also can give you some really good growth overall I think it's pretty fairly valued and consistent. And I'm not talking about the hype behind weight loss, drugs, buying eli Lilly at 100 times earnings for that, but a lot of brands within that sector that are very, very prudent capital management, very consistent cash flows, increasing dividends I really like. So healthcare might be the only sector not mention that. I know you're a fan of Two. But you kept it to three.

Yeah, yeah, I do like healthcare. I think there are some political considerations there that make that sector a little bit harder to predict, especially in an election year. But yeah, that's a good one. Yeah.

And I think too within that there's just various segments within that like are you in biotech, are you in hospitals, are you in pharmaceuticals, medical equipment, by the way, on the medical and dental equipment I'm seeing a lot of Patterson just reported earnings not too long ago and they did not do well. It seems to be an inventory build. I'm just curious if any of our listeners are seeing any price reductions because their, their earnings report certainly indicated that might be on the horizon. So healthcare equipment manufacturers seem to be struggling a bit. Doesn't seem to be a lot of capital expenditures in either the dental or medical space which is just a unique tie in from sort of a more macro development to something close to home for our visitors. I personally haven't seen it seen much of a difference with my interactions with clients on equipment deals and that sort of thing. But I'm putting this out there to our listeners and seeing what happens over the next six months because them Align and Henry Schein seem to be building up on inventory on the aggregate level. Just an interesting little tidbit I've sort of picked up on. Well and maybe pivoting from the sectors. I mean where do you think interest rates are going from here? I mean obviously none of us know, not even in my opinion and I believe them at face value. Not even Jerome Powell, the guy who sets them with his committee knows specifically. But maybe what's your take on let's call it the next 12 months which to me is a pretty short timeline on where the Fed rate goes and where you think the longer term treasury yields which by the way listeners, that's what drives mortgages. Rates on mortgages, rates on practice loans, equipment loans is more tied in with the longer term bond market than the overnight rate that the Fed sets. They interact but that's more the driver. But in any case Brandon, what's your take on both of those short and long term?

Yeah, it's a good question. Like you said, even Jerome Powell who's helping set the overnight benchmark rate is not sure probably where we're going to be in the next six months. It's definitely something that's a little bit unpredictable. I will say looking at the rate movement that we're seeing today where rates the 10 year was just at 5% I think it actually hit even 5.1%. And now, now it's pulled way back. And so to see that there's a couple things at play here and it's really difficult to figure out what's going on in the economy because if rates are coming down because inflation's coming down, which that is the case, we're seeing it show up in the numbers that would say that longer term rates should be coming down. However, if we are going to hit a recession, I think most people do think that we're not going to hit a hard recession. But you know, any recession whatsoever would also result in rates coming down because that's going to start to price in Fed cuts on the shorter end of the curve and therefore longer term rates are going to decline in anticipation of those shorter term rate cuts. So I tend to think that we're probably leaning more towards a softer landing. Personally, based on the data that I'm seeing, I wouldn't be surprised if unemployment, which we're going to get those numbers on Friday of this week, don't be surprised if that kicks up to over 4%.

And that's by the time really, that's really what they're targeting right at the Fed.

Right. That's, I guess where I was going to go with that point is some of the times you think that this is bad news and the reality is the markets will react positively on what you would perceive as be bad news. So if unemployment does increase to be over 4% and we get that number on Friday, don't be surprised if the markets actually rally on that news. And if it's below expectations or even stays flat at around 3.9, don't be surprised if you see a little bit of a pullback because that's probably indicative that the Fed has more room to hike. So the Fed has a dual mandate, right? And it's employment and inflation. And anytime unemployment is low, that's one side of the mandate that's giving them Runway to tinker with the other side of that mandate, which would be inflation. Now, if you start to see unemployment tick up a little bit, which is what you would expect to see with everything that we're seeing outside of the unemployment number, then you're probably going, okay, well maybe the Fed's going to hold rates steady here and wait a little while for these other rate hikes to start to kick in. Because to Paul's point earlier, it can take six to eight months or more for the last rate hike to filter its way through the economy. And I believe the last hike was in July.

We're not quite to the point to where we've seen the overall impact of what they've already done filter its way throughout the economy. With that said, you also have quantitative tightening and the fact that the Fed is running at massive deficits each year probably for the foreseeable future, for the next 10 to 15 years. I think they're projecting issuance from the federal government of over $20 trillion. So now you've got a supply issue where the government needs to raise money, basically the treasury. And so they're going to auction with bonds and who's going to buy these bonds and if the demand's not there, then you're going to see the longer term rates kick up or wherever they're issuing these bonds on the curve. If it's a 10 year and there's not much demand there, then you're going to see the 10 year rise. If it's a 20 year or 30 year, you're going to see the rates rise in the 20 and 30 year. And it's interesting because the federal government is actually starting to target maturities taking into consideration the yield curve, which is the first time they've done this in history. For example, they recently announced that they were going to auction bonds around, I think it was 10 years, primarily because the longer term rates have moved up so high that they were actually a little bit worried about doing a longer term auction and then driving long term rates up even higher, which could have unforeseen consequences obviously on bank balance sheets because they're holding a ton of long term debt. And when rates move up, holding losses increase pretty substantially for somebody who's holding a bunch of bonds on say the 20, 25 year maturity time horizon. And so I wouldn't be surprised, Paul, if in the short run we see a bounce back in rates, especially the 10 and 30 year, which appealed back quite a bit over the last three weeks. I wouldn't be surprised, especially on the long end of the curve, if that continues to tick up over 5%. So we could be sitting here in two or three and the 30 year be above 5% again if inflation continues to come down. I still see a scenario where longer term rates continue to go higher just simply because of those supply constraints that I was talking about with the government issuing those bonds and then the tightening in that they're no longer buying bonds, they're letting them roll off of the balance sheet. There's $7.5 trillion, Paul, you probably know better than I do on the Fed balance sheet at this point, but it's pretty large. That alone, I think can increase long term rates even while the Fed cuts short term rates. And that's probably what they want because that's going to result in a steepening yield curve. If we can get the 30 year up to 5.5% and then at the same time the Fed cuts the short term rate back down to it's at 5.5 today or somewhere around there, but let's say they cut it down to 3.5%. Even now you've got a pretty good yield spread between a 30 year and the overnight rate and that's a healthy economy. When you have a steepening yield curve.

Like that, pretty logically, rates and time are typically positively correlated. So if you borrow money over a 30 year time frame, over a one year time frame, you'd expect to have a higher interest rate over a 30 year time frame. Fairly logical. That concept of the relationship between time and interest rates in the debt market is called the yield curve. And Brandon spoke about that. And one of the unique occurrences we're facing right now is an inverted and flat yield curve where it costs more to borrow over the short term, over the long term for the treasury. And that impacts what businesses are buying borrowing rather that impacts how consumers are borrowing. Like I said, the 30 year mortgage rate is more tied in with the 10 year treasury yield than it is with the overnight rate. And so what the bond market is telling us is in some ways a little bit of a, we're calling the bluff. We don't think the Fed's going to continue tightening. We think rates are going to be lower and that's why we have more demand for these longer term debt instruments. And the rally, especially over the last 30 days, is really a head scratcher. It's very much a counterintuitive point. When you can borrow at five and a half, why would I buy bonds that are giving me.

Four and a quarter over the next 10 years? Which is essentially what's happening as of this week. I think a big wild card in all this is, like you said, Brandon, fiscal policy and how much the treasury is borrowing. And historically, over the past, I mean, pretty much since the financial crisis, the Fed's been the biggest buyer of debt issuance of any institution. They hold the most treasury securities and they're not buying.

They'Re letting it run off. That's quantitative tightening. When they're saying, hey, we're not buying more of these bonds, we're just letting our shorter duration ones expire and not buying more on the other end, to me, it feels like the bond market's pricing in that that's not continuing. I mean, that's a little bit of a speculative remark there, but I'm having a hard time seeing the logic on buying 10 year treasuries at a 4% clip right now. Unless you felt like, hey, the Fed's going to be back buying here soon because the supply side of the equation is certainly going to grow. It's all but guaranteed. I don't know. What are your thoughts on that? Do you think that the quantitative tightening side of it is going to hold through next year?

That's a good question. A good point you make. I think back to what we originally, when you mentioned watching Jerome Powell's speech recently, one thing that you took away from it was he was going to be data driven. And that's kind of the fundamental thing. He keeps going back to and has been saying that for many quarters now. I think that the answer today, if you asked him whether or not quantitative tightening would continue, he would probably respond in a similar fashion, basically saying that until something shows itself, then there's no reason for us to change course. Now, if rates go up so significantly as a result of tightening and this could happen, and also with longer term bond issuances, with the government having to raise money and things like that to fund these deficits, if we see the 30 year bond rates start to go above 6, 6.5%, 7%, that's where I think you're going to see a course correction at that point. But I think the good news is, at least for me, I view it as good news, is that the Fed's looking at these things and they're willing to adapt or change their response based on what they're seeing in the numbers, that tells you that they're not just going to make an announcement and stick to it and not take these things into consideration because they are important. But at the same time they're not going to act prematurely either and anticipate something's going to happen and then change course before it actually shows up. They're going to let this thing play out. Personally, I think that they have a little ways to run with this tightening. I think that there's enough demand and I think that they need to. I think what's resulting here is the Fed is really in charge of the shape of the yield curve right now and the volatility that we're seeing is unprecedented. We shouldn't see 30 year bond rates, 20 year bond rates move like we've seen even the 10 year going from over 5% to just shy of 4.15 in like two to three weeks. So that's a little bit concerning. Right. But that's partly due to this unprecedented nature where we're in today, where the Fed is really in control of the yield curve.

Yeah. And they've been catching a lot of heat in any sort of media outlet this year and a lot of esteemed investors or esteemed individuals in the investment and business community have sort of been at odds with their decision. You know, no one's asked for my opinion, but I think they've to this point in this tightening cycle done a pretty, pretty good job. I mean, they really haven't surprised anyone. They've stuck true to their word even if it's an unpopular one or even if it's a hey, we're doing nothing. And they've kind of stuck to that. If I'm going to fault them for anything, it's that they waited too long. Right. I think that we were. Money shouldn't be as easy as it was in 2020 and 2021. That's just not the way capitalism and economic works. Right. And I think I'm a lot more confident in the longer term, sustained health of the economic backdrop today than I was in 2021 in that the party had to end sometime. And I think going forward, I think folks, I think the everyday individual, I think always have a healthy, not concerned, skepticism or caution. I think that's always the case. And be smart. When money costs money, you get back to the basics and the fundamentals. It's don't be over levered, stick to a budget, stick to a plan. And the same is true with investing. Buy businesses that haven't taken on too much debt, that are being opportunistic with acquisitions that have a good product line, that have good margins, that have been around, that have proven they can sustain and in some cases even thrive in more challenging economic backdrops. And so going back to our discussion on valuations and the froth and the lack of breadth in the S and P. The S and P, if you ask me, where I think it's going to be next year, I don't really know because I could see the magnificent Seven coming back to reality. While breadth picks up in a lot of these good businesses that are unloved get priced to a more true intrinsic value or reality. And then the other side of it is when we have these tightening cycles, I mean historically they haven't ended well. Something breaks and that's also a possibility that I think people, I don't think it should be the primary driver of decision making, but it should be in the back of your head that historically something breaks. There's a lot of people trying to predict how long it happens after inverted yield curve or at what point in the economic cycle or that sort of thing. So far it doesn't seem to have broken. But unemployment can look good one month and then if it starts to pick up, it can get to a point where Fed swiftly reverses course to be accommodative. So I don't know about you, but as much as I have beliefs and I tend to agree with you, I would expect longer term rates to rise and I think next year I would expect to see short term rates to come down. I think the 10 year yield should be closer to 5 right now I think that feels like a good mark. With a premium over inflation and supply and demand imbalance and so forth, it doesn't matter what I think, but I'm of the opinion that really any outcome is a possibility. I think that's a healthy framework to live by. I do know that we did take advantage. So for context, you may have mentioned this in a past broadcast, but 12 months ago if you looked at our fixed income allocation, it would have been almost all short term bonds which historically pay a little bit less, but when rates rise they don't suffer. Whereas longer term bonds, a 30 year treasury over the past year might be down 30, 40%. As rates have risen, we've started to increase duration to take advantage of that. Now that was when we saw 10 year yield jumping up towards 5%. Now that we're at 4%. What do you think in our portfolio allocations, Are we reacting to that? Do you think we're well positioned? I mean, what's your take on the more current developments?

Yeah, that's a good question. And with the swift move in rates, I kind of view that as I make long term decisions with stocks and I do the same thing with bonds and so the peel back in rates right now, it could indicate that maybe I could decrease duration because rates have fallen so much, but we just extended duration when they were above 5% which was only two to three weeks ago. I like where we're at, I like to continue to increase duration. I do think that rates are probably going to bounce back and by that I mean the longer term or the longer end of the curve, like 10 plus years and out. And so I'm not necessarily increasing duration. Now we did increase duration when the 30 year was above 5.1% and as it marched there like from pretty much from 4.5 to 5.1, I started buying into longer term bonds, being more like 7 to 10 and even 10 plus years we were buying into those. Would I continue to increase duration where we're at now? No, but I'm not going to decrease duration. I'm just going to pause and let this work itself out and collect the yield because the yield on those longer term bonds, it's still good and there's no need to make a change right now based on what I perceive to be a short term volatility move in the interest rates.

So you guys talked a little bit about the changes or portfolio ideas that you have around bonds, specifically based on the current economic environment. But do you have any commentary on the equities and other asset classes that we hold within their accounts and how we're building their portfolio around those expectations?

Yeah, I think overall probably from a tactical perspective, meaning decisions that I'm making to try to outperform or add some value to our client portfolios, there's been a lot more opportunity, I would say on the bond side, we've been talking about increasing duration because we were primarily short term bonds while interest rates were rising, if you will, which drove down bond prices. It was a little bit more obvious that that was a good area to bet against, if you will. When rates are going up, let's stay on the short end. And as they get to a point to where we think it's more of a normalized interest rate environment, say 5% on the 10 year, then start to extend that duration and that's what we did. Now on the equity side, my viewpoint on equities hasn't really changed over the last two years, three years, and that is that growth is extremely overvalued. And when I talk about growth, I'm primarily talking about two sectors, communication services, which is comprised of Google and Meta companies like that. There are some good value plays in communication services like Verizon, which trades at a very low PE and pays a high dividend. But given that that communication services is such a large part of it now is driven by technology, it's almost like one in the same. The two sectors that I think are highly overvalued would be those growth sectors, communication services and technology.

I've been doing the same thing that I'm doing for the last several years, which is reducing our exposure to those sectors and increasing exposure to value sectors, value being those sectors that are trading at lower PEs and have high earnings growth, have good cash flows and pay good dividends. That's really been the playbook drew for equities. Now, that hasn't worked out quite as well this year. It worked very well last year. But what we saw this year was some of those sectors that underperformed last year, I.e. technology and communication services, they bounced back, particularly the first three to six months of this year. The outperformance of those sectors has really driven the overall broad benchmarks like the S&P 500 and things like that. But overall, I do still think value, especially in a high interest rate environment, value is actually going to work out to be better in the long run over the next two to three years. I do think value is the place to be. One thing that I think supports that is if you look at the Fed now not needing to cut rates immediately after their hiking cycle, traditionally, by the way, on average, it's about eight months between the last Fed hike and the next Fed cut. And so we're only about five months into that process because like I was saying earlier, I think the last hike was around June, July time frame, and that's average. And so if the Fed can hold off cuts until the second half of next year, that's not going to bode well for these high PE stocks that don't pay as good of dividends. We should see some of that reverse. Some of this is hypothetical and I'm revealing some of my opinions here, but that's kind of what drives that equity allocation that you were talking about and how I position myself for our clients and how I invest. Paul, do you have any thoughts there?

Well, other than being largely on the same page, I think there's good businesses to invest in in this market, but there's a lot of overvalued businesses and we're hearing mostly about the overvalued ones, in my opinion, of course. And I want to clear something up for any listeners that you know. Value versus growth can be somewhat of an antiquated categorization. But in general terms, I get this question at times, like why are you not into growth if it's going to grow more over time? That's not necessarily what that means. A growth stock is classified that way simply because it's trading at a higher multiple under the expectations that it's going to grow its earnings faster. So you're paying way more per dollar of earnings today under the expectation that it's going to grow its earnings at a higher clip, whereas A value doesn't necessarily mean it's a dinosaur company going out of business. It just means that these tend to be more mature businesses. Maybe they're in, a lot of them are actually growing their revenues and earnings at double digit rates, but the market has placed a lower valuation on them per dollar of earnings for whatever reason, some good, some bad. And the point I'm trying to make in that is that the value side of the equation, the companies that are strong fundamentals, that have weathered recessions, that have a proven track record of returning capital to shareholders, those tend to outperform unless the rules and the laws of finance have changed, which just when you think they do is when they remind you that they never change until those rules change. I'm with you on that. I pretty much always have a value bias, but especially right now, especially right.

Now, what is only like two or maybe three times in the history of our economy where growth has outperformed value in a rising, rising rate environment. So I think the market at large would agree with the sentiments that you guys just described there. And I kind of think about, you know, in my terms like how you guys are describing the pausing of the rate hikes and to kind of let the action that they've already created take hold in the marketplace and see what other things may break. As you said earlier, Paul, and I think that, you know, the timeframe from the last rate hike to the first rate decline that Brandon mentioned of eight months, we're only sort of at the five month mark. And then most of the talking heads in the space would suggest somewhere around end of Q2 would be the most logical time frame for people to or for the Fed to start lowering rates.

As growth companies and their capital structures get more exposed to this higher interest rate environment, there's definitely still more room for things to break and create some more chaos in the market that hasn't happened yet. Given the fact that we potentially have another six to eight months before the next rate decline, I think there's still a lot of room for the storyline for value to do well or outperform growth as sort of your expectations led you to construct the portfolio as you guys have. So this is just some of my general thoughts on that as well. Any other points that you guys want to make?

And Drew, I want to make a comment specifically on what you said, that it's helpful for folks to remember that the stock market's trying to predict the future. Right. So you can see a rally, which I believe is what's happening now on the expectation of a future event. And I think that the market's really got its fingers crossed and really eyeing a Q1 or Q2 rate cut and that's why you're seeing this rally. I think that's a big, big part of it because. Because it's completely irrational under the backdrop of today's interest rate environment that I think the market and investors are trying to get a jump on on when that will will occur. But the reality is we just don't know. Stock market's always right in the long term and always wrong in the short term. I think it's a great way to great thing to remember when you're investing, right?

Very, very true. How do you guys think that the cash reserves at the personal level from the fiscal stimulus that was sent out after the COVID situation happened, how much of that do you think is also happening at the corporate level and therefore allowing them to have a little bit more time before their capital structure really does need to get exposed more to the higher interest rate environment?

I think that's a fair question and I think you're going to look in different sectors of the market and see very different results. I think it's something that Bran and I both really and it's fairly similar to how you look at your clients. Like leverage is an important concept piece and understanding the health of a business in the aggregate. I think that businesses in general are well capitalized. To be totally honest. I think we have some potential issues that in some of the smaller banks like we saw what happens if people decide to pull their money. I think on the other end I still like financials because the larger banks are historically capitalized and they can be opportunistic when things like that happen. I think there's businesses that weren't smart in how they were restructuring their loan maturities. And so when we're seeing if we see a business that has maturities of their own debt that they can't organically finance with their cash flows now and they have to re up at a 6, 7%, you know those sorts of businesses are going to run into into trouble as well. As far as the stimulus runoff and sort of that juice, I think there's still elements of that. I think another thing too that may not catch every headline but some of the policies implemented in the past 12 months in this administration, Inflation reduction act infrastructure and the CHIPS act, we're seeing that flow into different sectors in varying degrees. Tech, kind of bash tech. But there's segments of the semiconductor space that I think are still pretty fairly valued and worth a really good hard look at it. So I think it's very much a sector specific dialogue, at least on the corporate front. And then on the personal level, our clients tend to be fairly disciplined and so forth. But the average American is struggling. I mean, make no mistake about that. Consumer debt is rising. Average payment per month for housing, auto and so forth is very much outpacing income growth. So there could be some issues that bubble up on that front. But I think the corporate environment is a little more nuanced than that. Brandon, what are your thoughts on capital in general and debt loads?

Yeah, it's a good question. I think I agree, Paul, is that these things are. Not everything can be predictable by sector, but there are certain things that you can look at and certain sectors are impacted vastly different than other sectors. For example, technology historically is very low debt. You take a big company like Apple and you dig into their balance sheet and you realize that they don't necessarily have to go out and get a loan or refinance a loan or at least relative to a utility company which has a ton of debt and has to constantly refinance that debt. So what you look for is the average maturity of a company's debt. If it's two, three years, four years, five years, that's an indicator that they probably had a very good rate when things were great. Like everybody got 3% mortgage rates on their homes five years ago, three years ago, we all benefited from that. These companies benefited in a similar way by financing their debt at that time. Some of them didn't extend it out long enough, meaning 10, 15 years. They did a shorter term loan. And those are the companies that are going to be at risk here soon because they're going to have to refinance, say 2.5%, 3% interest rate debt into 7%, 8%, 9%. That's kind of where auto rates are at right now, is like 7, 8% for good credit. When you see those types of rates, you start to realize any company that did not extend duration on their debt when times were good, they're going to probably be paying for that here in the shorter term. Then just a comment on what you both talked about, Drew and Paul talked about earlier in terms of expectations for Fed rate cuts. I just wanted to just make the point that earlier this year there was an expectation that the Fed would cut rates by the end of this year.

When we're talking about Fed expectations, it's just important to remember that these things can change so quickly. And now the overall expectation, and by that I mean greater than 50% chance. There's a greater than 50% chance that the Fed is going to cut at least once, something like that, by the third quarter of next year or the beginning of the second quarter. That's kind of where the expectation is now. But about four or five months ago there was a very high likelihood that they would be cutting by the end of this year. The point there is, if that doesn't come to fruition, if we are sitting here next year and it's March 2024 and inflation is at say 2.5 or it's trending, it's still continuing to turn downward. Unemployment hasn't increased substantially, maybe it's above 4% like we were saying earlier, and it's maybe approaching 4.5%. Don't be surprised if the Fed doesn't cut rates because things are actually trending pretty well and they're going to buy their time. Partly because of what Paul indicated earlier was they made some mistakes on the front end years ago, they kept rates too low for too long and that led to this inflation spiral. And so.

Just keep that in mind, is that I think overall Jerome Powell has learned a valuable lesson in that and he's going to be more likely to sit on his hands and not do anything before he cuts prematurely. We all have these expectations and that gets baked into these stock prices on a day to day basis. But how quickly they change is something that we forget because as time gets closer and closer and it starts to pan out, we forget what the expectation was three, four months ago. And so I see a situation where are we possibly going to see some cuts next year? Maybe Is it going to be in the beginning of the year? I think something probably has to go. We're going to have to see some pretty significant changes in the data points for that to happen. Also, is it going to be in the second half of next year? Probably. But there's also situations where that's not necessarily going to happen either. If you're heading into that situation where you're not going to see rate cuts sooner, rather later, then you're going to actually be more supportive of buying value stocks because that means rates can stay higher for longer. The Fed doesn't have to cut as soon and that's going to be more beneficial to those value stocks that we were talking about. Just some things to consider there. I know it's a lot to take in, but those are all the things that I think of when I hear these expectations and how it's going to drive the stock market in the future.

It was a whole lot easier a year and a half ago when the Fed came out with their rate hike schedule that they stuck to religiously during that whole 18 month period. We're looking a little bit more in the unknown right now. How do you guys assess the wage inflation? You know, for the one over the last like three months, it started to finally outpace the actual inflation rate itself. So it's holding at around 4 or 5%. And I bring that up only because our clients in their, their exposure to inflation is going to be a little bit more heightened around wage inflation just given their stat costs are increasing. I think that we all as advisors, dentists and dental specialists are seeing that every day. And so anyway, my question is more on the fact that it's still staying relatively consistent as broader inflation is seemingly coming under more better control.

Yeah, I mean, from a macro perspective, I think that's a really good tell wage inflation, because that is significantly more challenging to control than supply and demand for goods. Right. And it can tell you what the reality is under the hood of inflation. If businesses are paying more for staff, they're going to have to price it, pass that on to consumers, whereas commodities can ebb and flow and supply and demand driven. And so I think, I think that kind of reinforces our take and what Brandon said specifically, that if employment, if unemployment rises to 4%, that sounds bad. Again, it stinks when people lose jobs. But at the same time, there needs to be a little bit of softening on the labor market. We can't have a scenario where it's an upward spiral on what we're paying hygienists and other folks in other various industries with unemployment rising a bit. Like I said, I think the Fed is anticipating and wanting unemployment to be in the low fours. You'll probably see that softening as employers have a higher pool of candidates looking for work. We'll see that softening and that would probably be a pretty good indicator that we may be approaching the end of the tightening cycle and inflation is firmly under control. That'd be my take on it.

I think it was a great take. And even in our industry we're heavily dependent on people in the professional services space. Right. And Dennis are professional service providers as well. And I think that my point I'm getting ready to make is more along the lines of when you look at broader inflation and then you try to just figure out what your real inflation rate is, it could be quite different in some Cases, especially in dental, maybe even when it's higher on the, the wage side of the equation, their real inflation rate could be much higher than what's being experienced right now across the broader, broader market. And the last part I want to talk to you guys is real estate is a common thing that we, a common topic that we have. Our client pool is from the ages of 29, 28, really all the way until retirement date. So real estate is always going to be a play for these people that we're working with. And just curious what your take on the current real estate market is, how interest rates and inflation are impacting that and maybe even speak to a little bit about the baby boomer turnover and what that could potentially mean for the increase of supply of real estate and how that may impact the pricing moving forward as well.

Yeah, those are all good questions. I think the baby boomer supply thing that you bring up, it was recently in the Wall Street Journal actually. And it's one of the things that people are trying to figure out, when's the supply equation going to kick up in the real estate market? Because right now there's a lot of red tape, if you will, to build and everyone locked in, like we were saying earlier, everyone's locked in 3.25% in some cases, 2.75% 30 year fixed rate mortgages. And so they don't have an incentive to sell. The reduction in supply, meaning the amount of homes that are coming onto the market for sale, has actually created this stubborn housing market situation that we're in now where prices are still very high, even though interest rates are extremely high. And we're not two, three months into an interest rate cycle. We're 18, 19, 20 months in. Now. At what point do you see the real estate market start to decrease, which is what you would expect in an interest rate rising environment. Not only that, if the Fed's trying to bring down inflation, CPI housing makes up 40% of that number. Make no mistake about it, the Fed is not going to accomplish their objective, meaning they're not going to bring inflation to their 2% target until they've cracked this housing market. And they haven't done that yet. I do think that the supply issue could be partly resolved by that. And that would be the story panning out here would be that baby boomers who are older have held their houses for so long, they've got significant equity in their homes and now they're going to sell those homes. Take a Southern California home for example. Somebody bought it for $75,000 in the 70s. It's now worth $1,800,000. They're going to sell that and they're going to set sail into Florida or some other more cost effective state and set up shop there and then live off of the equity that they made in their home. I think that that's a big part of what could drive supply higher. I honestly don't think that that's going to be the tipping point. I think what the tipping point unfortunately is going to be is when people actually default on their homes or.

They'Re forced to move and they're not moving because they don't want right now they're not moving because they have that locked in long term rate that I was talking about. But when unemployment up to 5%, 6% even. This doesn't have to be the national number by the way because this can be very different state by state. But in California the unemployment rate is much higher than other states partly because we're more heavy in the technology jobs sector. Tech jobs, Google Meta. These companies have been laying people off for quite a while. Our unemployment rate as a state is higher than the average state in the country then that can result in people being forced to to sell their homes. I think the baby boomer is going to be one component of that. But I honestly don't think we're going to see the softening that we need for inflation to get back to the 2% target until we actually have some more pain on the unemployment side. Paul, what's your take on that?

Yeah, first pretty wholeheartedly agree with everything you've said but I want to be clear that softening of a housing market isn't inherently bad. It's just in many cases necessary. And not all cycles result in full on disasters. Right. We have this recency bias. The last time the real estate market corrected it was a disaster. That doesn't necessarily have to be the case. Some unfortunate people can default and have to sell and not get 500 a square foot like they're getting this past year. And that can result in a more normalizing process. And so I think that's definitely an outcome. That's probably my, I would call it my base case versus a full on disaster. I think the area where we're seeing we could see some more disaster type is in certain segments of the commercial real estate to be quite honest. I don't think that we're going to see problems in like industrials and warehousing and stuff like that. If anything demands only increasing for those. But in office space. Right. A lot of white collar jobs have moved to homes and those leases had various maturities and not all of them matured in 2021. Right. You think of a business particularly in a big office setting, I mean a lot of times, 5, 10, 15 year leases, as we see those mature and demand soften for those. I'm interested to see what happens in the commercial space. Healthcare is always a safe bet in the long term in commercial, like I said, I like industrials, but then some more volatile segments like biotech, office space that can be more problematic than the residential side. But I think there's always a case to own real estate. I think every client should own real estate, even if it's just simply their primary residence or in many cases their practice to get some commercial exposure. But yeah, I would agree with you, Brandon, that I think my base case is a softening. I don't know that I'm calling for a disaster, but I think we're going to have to have some pain. The math doesn't make sense for the average American. And at a certain point someone's got to pay the rent. Someone's got to pay the mortgage and that just I think has to.

Normally expectations around interest rates right now are broadly that they will start coming down halfway through next year, second half of next year, sometime. There's also an incentive to wait because as rates come down, you kind of have the reverse effect on real estate asset prices. So I think there could be some supply increases that come through this sort of all filtering out and getting to the end of that there.

That's contrarian, but it's a good point that if rates come down to like 5%, you might see supply increase, which is counterintuitive to how interest rates interact with real estate. You might see supply increases and price come down because someone might be more willing to get out of their 3% to downsize than today. You'd have to pry them out of that house to get into a 6.57% mortgage. So I don't know that we've ever had that confluence of factors where a softening in rates could actually be maybe not catastrophic, but in some ways negative to housing prices because now people are more willing to move. Brandon said that people aren't willing to move and I think that's an excellent thing to keep in your mind right now.

Yeah, just another point here is that right now the spread between the 10 year and the mortgage, 30 year mortgage is what it is. Say it's 2.5% because I think the average mortgage right now for 30 years somewhere around 7.2%. The overnight rate is sitting around 5.25 and 5.5%. Do the math on that and you're sitting somewhere probably around a 2% spread between a 30 year and the overnight rate. Now if rates come down on the short end of the curve, that doesn't necessarily mean or Even if the 10 year comes down to say 4% in order for the 30 year mortgage rates to decrease, you're also assuming that spread is not going to increase for other reasons. As people start to lose jobs and that unemployment rate starts to tick up, you'd expect to see an increase in spread actually. So just to play devil's advocate there. Yep, to Paul's points, that risk premium can actually increase as the 10 year treasury yield decreases. And even though the 30 year mortgage rates tend to loosely track the 10 year yield, the times where it will increase faster or have a disparity between the 10 year would be when that risk premium is starting to move, whether it be increasing or decreasing. I would make the argument that in today's numbers there's a higher likelihood that it's going to increase before it decreases because that spread is not very large to begin with right now and credit's pretty good, unemployment is fairly low and so it's really kind of only got one way to go.

So that's just recognize or talk about that often. Well, Paul and Brandon, it was a pleasure to have you guys on the show today. Before we adjourn here, are there any last words that either of you guys want to share with our audience?

No, really, just we talked about a wide variety of topics but in the reality, all these short term tailwinds and headwinds, they shouldn't matter. Stay the course. Time in the market is more important than timing the market. That's my personal take on everything we discussed.

Yeah, I agree. In general, just being disciplined and sticking to the long term strategy, a lot of the things we discussed today are things that are going to impact the market in the next one 12 months, 13, 14 months. But at the end of the day you want to stay invested, you want to stay in line with your allocation, your strategic long term allocation and stay disciplined and really don't let the short term turmoil rattle you to the point to where you want to sit in cash and miss out on these market moves that we're going to experience Some.

Of the aspects on. When you're comparing your investment returns to other people, it's a little bit of a tortoise in the hair analogy or metaphor. And the long term vision that you guys just made great summary points around is going to be the tortoise in that metaphor. And I think that the topics that you guys all discussed today are all really points for our audience to consider. So thank you guys both again. I really appreciate it. That wraps up another episode of the Dental Boardroom podcast. Until next time.