Lessons from Turmoil: Taking Advantage of Volatility
Peter Essele, CFA®, CAIA, CFP®, is vice president, investment management and research, at Commonwealth Financial Network®, member FINRA/SIPC, the nation's largest privately held Registered Investment Adviser–independent broker/dealer. With the firm since 2004, he oversees asset allocation, fund selection, and overall management of the firm's discretionary platform, Preferred Portfolio Services® (PPS) Select. Peter sits on Commonwealth’s Corporate Social Responsibility (CSR) Committee. Peter graduated from Union College, where he earned a BS in economics. In addition to holding FINRA Series 7, 24, 31, 53, and 66 securities registrations, Peter has the CAIA and CFP® designations and is a CFA® charterholder. He is also a member of the Boston Security Analysts Society.
I spoke with Peter on February 24.
Russia has invaded Ukraine. How should advisors view that action from a short- and long-term perspectives?
Folks would probably be surprised to hear that I think it's an opportunity to not duck and cover. It's potentially an opportunity to reevaluate and take advantage of areas that have been unnecessarily sold off because of Russia's invasion of Ukraine. Like I said earlier, if you're looking at a portfolio and it's, let's say 60% equities, 40% fixed income heading into the year, that's probably closer to a 55/45 at this point. Maybe investors want to take the opportunity to rebalance exposures and get back towards your stated objective, which would include buying areas that have sold off because of the volatility. It may be painful in the near or intermediate term. We could see some continued downside. However, history tells us that taking advantage of sell-off environments plays out well for investors over the long run. I don't think this period of volatility is going to be any different. There may be some additional downside. But now's the time you want to think about adding risk back into the portfolios and selling those safe-haven securities.
Looking back at the pandemic did it offer similar lessons about investing?
First and foremost, it's taught us to avoid those knee-jerk reactions during periods of stress. I realize that that is much easier said than done though. My suggestion is that during periods of volatility, the best thing you could do is avoid the headlines. When you're constantly reading those headlines and watching your account values decline, all it will do is add to levels of stress. The natural reaction to any of that is to do something. But the best option, as we know, is to stay the course and to not do anything or add to risk during those periods of stress. The mantra that we live by within my team here is that, as Warren Buffett says, "Be fearful when others are greedy and greedy when others are fearful."
That's exactly what Commonwealth did in March 2020 at the beginning of the pandemic when, as markets were selling off and people were rushing for the exits, our Investment Management and Research team added to risk across client portfolios in our $13 billion discretionary program. Let's say you had a 60/40 allocation, 60% equity, 40% fixed income, that dropped to 52% equity exposure. We bought on March 23, which happened to be the low of the market, 800 basis points in equity exposure across our portfolios and brought them back to a 60/40. As difficult as it is, my suggestion throughout those periods of turmoil and stress is to stay the course and/or add risk to portfolios.
To fully answer your question, the pandemic reinforced that notion that to avoid those knee-jerk reactions and selling out during periods of stress. There are many investors who effectively locked in 30% losses in those early days of the pandemic and never fully recovered their initial value if they sold out. That's the biggest learning lesson from the pandemic, from an investing perspective.
Since the end of last year, growth-oriented areas of the market have sold off while value has caught the eye of many investors. Is this the great rotation to value that some investors have been calling for?
It's certainly showing up in flows across our fee-based platform. When you look at Morningstar as well, there seems to be a preference from a lot of investors for value-oriented investments, which is not surprising. At Commonwealth, we've seen it in the inflationary environment over the past nine to 12 months, coupled with rising interest rates on the long end of the Treasury curve. Value has done well. Those types of environments benefit value-oriented companies: financials, energy companies. It's very similar to the period that from 2002 to 2008.
However, we still feel that growth over the long term is where you want to be positioned in your portfolios. That doesn't mean you completely exclude value, but we prefer to have a bias to growth. The way we look at is renting value, owning growth.
We want to rent value during these periods of out-performance, which will probably be short-lived. But over the long term, we want to own growth. That's what's driving our economy these days. If you compare the economy of 2022 to 1985, these days is driven by big tech, big data and healthcare. The top names in the S&P 500 are Apple, Microsoft, Amazon, Google. Those are growth-oriented names. If you go back to 1985, it was a value-led economy. You had GE, Sears, Exxon and General Motors. Those were the top names in the S&P 500. However, since 1990 growth has outperformed value most of the time, and that's going to continue. Take a market weighted exposure, slightly tilt towards the growth end of the spectrum, and that's going to benefit investors over the long run.
Interest rates hikes are on the horizon, with some predictions for four to five 25-basis-point hikes in 2022. Where will interest rates, particularly long-term rates, go from here?
As we consult with our affiliated advisors, we understand a lot of investors fear that Fed rate hikes that are on the horizon and what that will do to long-term rates. But a lot of people are missing and don't realize is that a majority of the interest rate hikes have already been priced into Treasury markets. Generally, investors don't wait around until the Fed ultimately starts hiking and sell long-term bonds. The Fed has done a pretty good job forecasting, or at least hinting at, what it is going to do throughout 2022. Investors have reacted to that and sold long-term Treasuries, which is why you see the 10-year up around 2%. Most the move has already been priced in on the long end of the Treasury curve. It's a situation of buying the rumor, selling the news.
From here on out, you would have to see additional hikes being forecasted and predicted from the Fed for 2023 to see a continued move higher on the long end of the Treasury curve. Most recently, as a result of the rise of rates on the long end of the Treasury curve, we've extended duration a little bit across our discretionary portfolios. We maintain a short-term positioning relative to the benchmark, which is the Bloomberg U.S. Aggregate Bond Index. However, we have extended a little bit, because we just don't see a ton of upside to long-term Treasury yields in the foreseeable future.
On that same point, many investors are rushing toward alternatives and short-term bonds in anticipation of a rise in rates. Is that the right play?
There's a cautionary tale within the alternative space. A lot of investors are moving towards alternatives as the panacea of fixed-income positioning that'll help preserve wealth in a rising interest rate environment. What investors need to realize is that in doing so, by moving from fixed income to alternatives, they are completely remaking the risk-reward dynamic of their portfolios. In many cases, they are taking non-correlated exposures – non-correlated fixed income relative to equities – and putting that into alternatives that have a high correlation to equities. At that point, there's no ballast left in the portfolio. You have everything moving in the same direction. If we get a market sell off, like we're going through now, your equity exposures are going to decline along with your alternative exposures.
We at Commonwealth still think that fixed income has a place in portfolios. It is meant to be the safe-haven, risk-off portion of the portfolio. The best way to look at it is as insurance. You pay for insurance. In the case of fixed income, it's a placeholder; it's insurance that pays you over time. I would caution folks against moving wholesale into short-term fixed income or towards alternatives as a replacement of their core fixed-income exposure.
Labor shortages abound, as evidenced by the large number of job postings relative to those seeking jobs. What’s going on? Where is the available labor?
There's obviously a clear shortage in labor. The U.S. has 10.9 million job openings, according to the JOLTS survey, and 6.5 million unemployed. If you gave every unemployed individual a job tomorrow, you'd still have close to 4.5 million job openings. That's a large shortage in workers. People had a chance to reflect on their situation throughout the pandemic and woke up one day and the music had completely stopped. People looked at their work situation, where they lived and ultimately what they want out of life. As a result of that, people made changes. We've just seen a great migration of people, particularly out of the Northeast and the West Coast, into warmer climates, like Texas, Tennessee and Florida.
Here is a quick piece of anecdotal evidence. I went to a U-Haul dealership, and I was looking at trucks. It turns out that to do a one-way trip from Boston to Tampa cost about $5,500, and to go the reverse from Tampa to Boston only cost about $900. There's been a massive depletion of U-Haul fleets in the Northeast. You've seen a great migration from certain areas of the country, and the labor that existed pre-crisis is no longer there.
In addition to that, you've seen a lot of people switching professions, particularly within the leisure and hospitality space. When the pandemic occurred, a lot of those people in those service-industry jobs, which in many cases people used as a placeholder while they're students or studying, to step to bigger and better things. When the music stopped, people took that as an opportunity to pursue their life's goals, whatever they may be. Maybe they went back to school or switched professions. That's provided a big kink in the amount of available labor within leisure and the hospitality space.
Finally, we've just seen the “great resignation.” Millions of people have left the labor force since the beginning of the pandemic, and there's no evidence of those individuals returning in a big way. A lot of couples and families have realized that by downscaling a little bit, they can live off a single income. With income rising, the shortage of labor, and the strong demand for labor, it's become more feasible for families and households to live off a single income. You've just seen a large majority of the working-age population either moving on to different things or moving out of the labor force. The combination of those three has placed a burden on the labor side of things.
Decarbonization is a buzzword that’s making headlines. Is the global economy moving toward a net-zero mandate? What does that mean for markets and investors over the long run?
I would encourage folks who are unfamiliar with the whole idea of decarbonization to take a look at Larry Fink's 2022 letter to CEOs. He's the CEO BlackRock. In it, he described this pivot towards a more sustainable economy and how decarbonization will create one of the greatest investment opportunities of our lifetime. I fully believe that. Just look at innovators like Tesla and how it has reimagined the auto industry, where every major car manufacturer is clamoring towards that electric future. But it doesn't stop there. You see the brightest minds across the globe working to decarbonize industries, like aviation, shipping, plastics and steel.
Regardless of industry, there are going to be leaders and there are going to be those who have failed to adapt and will be left behind. Those laggards will see declining market share, talent drain and withering profits, while the leaders will offer stakeholders that sustainable value creation that folks are looking for.
Sustainability, while it's just becoming more of a mainstream term, will be a key focus for investors over the next decade. At Commonwealth, we recognized the potential for growth in the SRI space early on. We launched a dedicated suite of SRI/ESG model portfolios on our discretionary model platform, PPS Select, in 2010. Today, every large asset management firm is clamoring to position itself as ESG-oriented. That's going to be a long-term, secular trend that's going to play out over the next two decades.
Do you have a preference for how investors should position their portfolios to be sustainably or ESG-oriented?
There are several different ways to do it. There needs to be an appropriate level of due diligence. There are several new strategies that are coming to market. That has muddied the waters a little bit, especially because we don't have a standardization in terms of rating systems for ESG managers. Either partner with a financial advisor who's well versed in this space, or with a firm like Commonwealth, who's been at it for more than a decade. We launched our ESG models in 2010. Make sure that there's an appropriate level of due diligence because there is clear evidence of greenwashing.
Greenwashing, for those who are unfamiliar, is taking an existing strategy and rebranding it as incorporating ESG principles and holding itself out as being ESG oriented, when in fact it's just a marketing ploy than a tried-and-true mandate. But we're moving in the right direction. The SEC is taking note of the ESG trend. When we look back five years from now, there's going to be a lot more for investors to be able to evaluate these types of names. But for the time being, there are several shops that have been in the space for decades. I'm not going to name names, but it's an easy Google search. I'd recommend folks look there.