Money Life: Will your portfolio be stranded when the tide goes out on stocks?

This interview has been edited for length and clarity.

Chuck Jaffe: Welcome to the Big Interview on Money Life. Joining me is Cheryl Smith. She is economist and portfolio manager at Trillium Asset Management. Learn more about her and the firm at TrilliumInvest.com. Cheryl Smith, it is great to have you back on Money Life.

Cheryl Smith: Thank you so much. It’s a pleasure.

CJ: It was only a little while ago that the market was acting like the Fed would cut rates six times this year. That has certainly changed. So how much is the Fed impacting the short term or is everything the Fed does right now just like ‘Let’s extrapolate that and see what it means in the long term?’

CS: I think it’s a really interesting mix of the two and there’s an inherent feedback loop in it. You’re right, earlier this year the market was expecting that the Fed was going to cut six times. The Fed said, no, we’re going to cut three times. And now the market is saying three times.

If you look at why the Fed might not cut yet, part of that is the financial conditions. Indexes that are showing the financial conditions really haven’t gotten as tight as you might have expected, given how much the Fed has already raised interest rates. 

The S &P 500 is going up and it continues to go up. Why does it continue to go up? Well, because things are still good. Why are things still good? Why do they look good? Because the equity markets are going up. So it’s very circular, and that’s actually characteristic of when an economy is getting ready to enter a recession is that things go really well until they don’t.

And the ‘until they don’t’ is the cliff drop, the sort of day when everybody wakes up realizes ‘Oh, the tide went out. I wasn’t thinking of that.’ That credit stress has started up. That unemployment has suddenly risen. That delinquencies are suddenly much, much higher than they were. And you start revising those price earnings ratios down. How much you’re going to pay for equities.

CJ: It’s interesting to me that you’re talking about the tide going out. Is it going to be sudden and, if it is, are you waiting until you wake up and realize the tide is out before making a move? Do we ride this wave all the way until we see that it’s gone? 

CS: I think that we prepare for it by a number of different actions. We don’t prepare for it by saying, ‘All right, I’m out of equities, I’m out of stocks, I’m not in bonds, I’m in cash.’ We prepare for it by saying, ‘What kinds of equities or what characteristics of bonds or the credit market do I want to be in?’

And I think that’s where you really want to be in quality. Because when conditions go badly, then having liquidity matters a lot. You also want lower leverage because when credit markets freeze, companies that have high leverage are going to have a lot of difficulty refinancing debt, they’re going to have difficulty meeting cash flow.

In 2007, we knew that there were big housing market stresses that were coming. We knew about predatory lending. We knew about a number of conditions. This time we know about commercial real estate. Okay. Commercial real estate post-pandemic is going to be a real problem, the huge problem in office buildings because people have decided that actually having flexibility about when you work is a really important part of a job and anybody who can bargain for that is bargaining for it.

One further step, companies or investors who have specialized in commercial real estate CLOs or loan agreements are finding that the safety that they thought they had was being sucked out from the bottom, just as it was in the CDOs and CMOs in two prior recessions. So even though you think you have a lot to support your credit structure, it’s really important to know what it is that’s supporting that credit structure and how quickly could it be broken.

CJ:  In these conditions, is international investing a safe haven and a diversifier or are international stocks and bonds coming from markets that are not as good as the U.S., so not so interesting?

CS: I think more the latter. I think that the growth prospects in Europe are worse. The growth prospects in China are worse. The growth prospects, Japan just moved from negative interest rates to positive policy rate within the last couple of days. I think that the growth prospects are just not as strong. 

The old saying used to be that when the U.S. sneezes, Europe catches pneumonia. I don’t think that has actually changed because of the size of the U.S. market. So protection from recession is not going to come from just automatically diversifying outside of the United States. 

CJ: You’re the economist talking about the big picture, but you’re also a portfolio manager. You’ve been telling us how you might reposition. What about alternatives in this, especially if international is not going to do it? What are the alternatives that I might gravitate towards?

CS: My feeling is that whenever you go into a market crisis — and I’m not predicting exactly a crisis, but I am predicting a slowdown and a recession — the simpler it is and the easier it is to explain, the better off you are. So in a time of recession, you don’t want anything that you can’t explain between the 11th floor and the ground floor.

Illiquidity becomes very expensive in times of financial trouble, so my feeling would be that you just simply say, ‘I accept that the return this year is not going to be what I would like for a long-run return, but I’m going to ride through that.’ Not ‘I’m going to try and find someplace with high yield. I’m going to try and find someplace that gives me some sort of kicker.’ I think that that unnecessarily complicates things and exposes you to more risk than you think you’re going to get.

CJ: And among those risks is the risk that, ‘Hey, can I actually ride it out with this thing that I’ve done? Can I follow this strategy through to actually see it pay off?’ The only thing that’s worse than going into one of those strategies is getting out of it in the middle of, of tough times.

CS: That’s an excellent point. Just a little anecdote worth thinking about — so many endowments decided to follow the Harvard and the Yale model of having so much in alternatives and so much in hedge funds. And, you know, they were getting these great returns, not understanding that Yale and Harvard are backed by huge endowments and a whole lot more cash-flow than any small endowment ever has. And so even though a Yale and a Harvard might have 45 or 50 % in alternatives, they still have enough in the rest of it that they could ride out 20 years until those alternatives begin to pay off.

It doesn’t work if you don’t have the liquidity cushion to do it. Big lesson in there for folks to learn.

CJ: So here we are talking about the trouble that you see ahead and everyone I have on the show says, you know, we’re not avoiding trouble forever. At what point does the market price this in and how long or short is this? And if you time this through the election, after the election, whoever wins, they’re a second-term president. They’re therefore a lame duck; lame-duck presidencies are not necessarily always known to be great for the market.

CS: I actually think that which of our two second-term presidents is the second-term president is going to make a lot of difference. They have very different ideas of industrial policy and economic policy. I would say that the stance on immigration is going to make a big difference.

One of the issues in the United States, as in every other industrialized major country, is low native population growth. The United States has grown because we have had immigration. If we cut off immigration, we will see a much slower economy for a much longer time. 

We also see big differences in terms of industrial policy or actually making investments in things. So I think it’s actually going to be material, which one of the two parties ends up in control of most of the government. And it’ll be a substantial difference in terms of what the afterwards growth rate is.

CJ: Most of the guests I have on the show say that while the election is a wildcard, it doesn’t necessarily affect the market. It only affects the economy. In this case, it sounds like it would be both sides of that, right? Are they disconnected? 

CS: Will the outcome of this election have a significant impact not only on the economy, but in how people are feeling about, am I reaching my retirement goals and the rest? Yes, I think it will.

Stock markets and bond markets are not going to behave well if you don’t keep some level of economic equity and some sharing of the wealth across classes. If you become more and more and more concentrated in a few people or a few companies, there’s a limitation to how far you can drive up the rate of profit. And since earnings growth and profit growth are what’s driving your equity market, it’s a self-limiting tendency.

So I think it matters. You can certainly go a year, two years, three years without seeing the effect of it. But over the long term, over a five-, 10-, 15-year period, it makes a big difference.

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