Podcast Episode 47: Revenge of the Nerds | Pt. 3

I’m as surprised as you are but apparently, people are deeply interested in the inner workings of Josh’s mind. In this episode, the guys continue to delve into the more technical aspects of their roles, including a discussion on some of the factors that go into portfolio construction and investment decisions.

Episode Transcript

BARENAKED MONEY PODCAST: EPISODE 47

Revenge of the Nerds | Pt. 4

Announcer:
You’re about to get lucky with the Barenaked Money podcast. The show that gives you the naked truth about personal finance. With your hosts Josh Sheluk and Colin White, portfolio managers with WLWP Wealth Planners iA Private Wealth.

Colin White:
Welcome to the much anticipated third episode in the technical side of things, where we let Josh off the leash to talk about more technical aspects of investing as requested.

Colin White:
So we’ve done two podcasts up to now, one on fixed income or bond investing, and one on equity investing. So we’re now going to talk about asset allocation or the process that one goes through to make an allocation to these two glorious categories. Josh, are you ready for this?

Josh Sheluk:
Oh, born ready, Colin. I’ve been ready for this for years.

Colin White:
I know. I’m I’m just going to get my pillow out, lay my head down and you know, I’ll chime in from time to time. So where do you want to start us on this large odyssey we’re about to embark on?

Josh Sheluk:
Well, just to be clear, so asset allocation doesn’t just refer to stocks and bonds or equities and fixed income. It refers to all the different types of assets that you could potentially buy. Whether it’s real estate or cash or cryptocurrency or gold or barrels of oil commodity, whatever it is in between.

Josh Sheluk:
So for our purposes here because they’re kind of the most mainstream, we’ll focus primarily on stocks and bonds, which is primarily what goes into most investors portfolios, but could hit a wide range of topics when you’re talking about asset allocation more generally.

Colin White:
All I heard was Bitcoin, Josh. I can’t wait to hear the Bitcoin allocation.

Josh Sheluk:
Yeah, we’re not going there, Colin.

Colin White:
Oh, okay. Fair enough. Well where are we going? Where do you want to start with this?

Josh Sheluk:
I think the important thing to realize right off the bat, stocks and bonds, obviously from our last two podcasts they function very differently. Generally speaking, stocks are going to be your higher return, but higher risk, higher volatility investment, and bonds are generally going to be your lower return, but somewhat stabilizing or lower risk investment.

Josh Sheluk:
So these two investment types will interact with each other in interesting ways within a portfolio. And it’s often that you want to invest in stocks while things are good, economically speaking. And when things are not so good, you want to invest in bonds or perhaps invest a little bit more in bonds when maybe you have a recession coming on or some issues in the stock market. So at a very, very high level, I just think that’s an important premise and principle for people to understand.

Colin White:
Well, I think it’s also important to understand that over time, over many time periods, it’s expected that either of those asset classes will protect the purchasing power of your money. And so they both can accomplish the same. As we’ve talked about before, the secret, the deep secret to investing is not about hitting it exactly right, it’s about never hitting it 100% wrong, and that’s why the balance is always important.

Josh Sheluk:
Yeah, absolutely. And I guess the other thing that’s important to say is, so as I kind of introduced there, if we see a recession coming on, if we’re hitting a recessionary time… Again, just to go back to what a recession is, the economy’s shrinking. There’s fewer people employed, people are earning less money, they’re spending less money. If people are spending less money, they’re buying fewer things and businesses are not making as much money so there’s profitability issues.

Josh Sheluk:
So when you have a recession, it makes sense that the profitability of companies is going down and perhaps those stocks of those companies become less attractive at that period in time. Whereas bonds, where you have an obligation to pay back a certain amount on your bonds, they can still be attractive during periods of economic turmoil or recession because it is an obligation to pay a set amount every month for the course of that bond.

Colin White:
Well, when we get into the weeds a little bit on this. I mean, again, recessions are defined historically, it’s two consecutive quarters of negative GDP growth. But the stock market is notoriously a voting machine as to what people think are going to come next.

Colin White:
So the effects of a recession can manifest themselves in the markets in advance of them actually being declared. Or when you see a commentator say, “We’re currently in a recession.” No, no, no. We can’t make that comment. We can think that we’re in a recession or recessionary times, but they’re only defined historically. But it’s the market’s forward looking I think that we have to try to keep an eye on.

Josh Sheluk:
Yeah. So what Colin’s saying is that if recession is coming six months from now, it’s not enough for us to know that because the stock market may already be reflecting the fact that a recession is on the horizon. So not only do we need to, I don’t think anticipate is the right word or predict is the right word. But what we’re trying to do is assess the probability that things might be worse off in the future than they are now, and perhaps a recession coming along. But if we’re seeing that, the stock market may already be seeing that, it’s a forward looking entity, a forward looking vehicle. So not only do we have to foresee that coming, but we have to foresee it coming ahead of the stock market.

Colin White:
It’s not a binary thing. It’s not yes or no, it’s nuanced, right? So I mean, again, it’s not just on or off. Is economic growth slowing? What does that mean? Is it going to go negative? What does that mean? How negative is it going to go? How long will it persist? Again, it’s on a continuum.

Colin White:
But internally we have a document that we use to frame our conversation about this and work through our own asset allocation for client portfolios. And Josh has authored a good chunk of it, and I’m going to basically leave it to him to kind of walk through and I’ll make the odd comment.

Colin White:
So the first economic factor that you’ve got listed here, Josh, is the shape of the yield curve and at this point I’ll direct everybody to go back and re-listen to the podcast on bonds, where we discuss yield curve in a little more detail, because now we’re going to assume that you know what a yield curve is, and Josh is going to tell us how that affects our prognostication.

Josh Sheluk:
Yeah, well, just to take a step back. What we think is super important with anything investment related is to have a process that’s in place and a discipline process. Something that you can follow systematically to make decisions. Because there are so many data points that are out there and so many emotions and feelings and news articles and fear and green and all of these things that go into your day-to-day, they factor into your brain. So you need to have something to keep all of these things straight and having a framework or having a process is how we do that.

Josh Sheluk:
So our process here has seven indicators that have been shown either through history or academically through research to actually provide some efficacy in making these asset allocation decisions, these decisions to buy or sell stocks and bonds. And that’s what we’re talking about here.

Colin White:
I love when you get excited, Josh, this is great.

Josh Sheluk:
First and foremost, one that I’m super excited about is the shape of the yield curve. So as we had talked about in our bond podcast, the shape of the yield curve is basically just a plot, it’s a graph of the interest rates on bonds for certain maturities. So one year bond, five year bond, 10 year bond, 30 year bond, et cetera.

Josh Sheluk:
The shape of the yield curve, whether it’s sloping upwards, so longer term interest rates are higher than shorter term interest rates, or sloping downwards, so vice versa, your shorter term interest rates are higher than longer term interest rates, has historically anyway, shown a lot of efficacy of being able to suggest that we may have a recession coming along and we may have sort of a cresting of the stock market coming along as well.

Josh Sheluk:
And it’s hit rate is probably something like 90%. So if you see what’s called a yield curve inversion, so short term rates higher than long term rates, that’s a pretty good indication that you should be getting more conservative with your investment approach, your asset allocation. And typically to get more conservative, you’re adding to your bonds and subtracting from your stock. So I would say that if you have only one indicator that you’re relying on, and for us, this is maybe the most important or most relied upon indicator, just because it has shown historically to be quite effective at doing so.

Colin White:
Well. I think it’s important here to dig into this a little bit deeper, Josh, because I don’t want people to have the message just like, “Oh, if it inverts, then I have to do something.” Because inversions happen at different parts of the yield curve for different durations at different times and there’s many different yield curves.

Colin White:
So it’s way more nuanced. Again, this is not a binary state. Different parts of the yield curve are important. How long, what markets, all that kind of jazz. So it’s a multi-headed monster that we’re looking at, but it is factually something that is important for sure. But it’s not, it’s not simple. It is simple, but it’s not to do the interpretation, figure out exactly the magnitude of the inversions that are being seen. Like we had an inversion at the shorter end of the yield curve not that long ago as an example. And I don’t know, did that persist, Josh?

Josh Sheluk:
No, it kind of reversed itself. I mean, you have like two year and five year rates that are somewhat inverted, but like very, very slightly and that historically has not really provided a whole lot of direction for you as an asset allocator.

Josh Sheluk:
Because the other part is, it’s not like yield curve inverts today, market peaks tomorrow, recession happens on Thursday, right? It’s not that simple. It’s like, okay, yield curve is inverted. Well, we may have a recession anywhere from nine months out to three and a half years out. Okay. Well that’s not that helpful, right? Because I need to get a little bit more specific than that. And that’s why, as you said, it’s very nuanced.

Josh Sheluk:
And I guess I should take a second to explain. The yield curve is effectively the market, the bond market setting rates. All the market participants are setting the interest rates on bonds by participating in that market. So why is the yield curve effective? Well, it’s effectively in assessment of the entire bond market, of all the participants in this market, of what they expect to happen with interest rates over time. So when you have a yield curve inversion, the bond market participants are telling you that they think current interest rates are a little bit too high, growth’s probably going to slow down, inflation’s probably going to come down, and all of these things are sort of negative economically.

Colin White:
Well, I guess it’s a good time to segue into the actions of the central banks and the federal reserves. How does that factor into decision making? And keeping in mind they set the overnight rate, they do not set any of the other rates that we’re we’re referencing in this conversation.

Josh Sheluk:
Yeah. So what we’re talking about here is monetary policy. So effectively the interest rates that are set in the economy, it’s not quite that simple, but I’ll simplify it for our listeners.

Josh Sheluk:
So when you have interest rates that are coming down, that’s making it easier for people to borrow money and therefore easier for people to spend money. And if you have interest rates that are very, very low, again, it’s making it easier for people to borrow, easier for people to spend.

Josh Sheluk:
And we’ve seen this effect with certain things. Like we recently did a podcast on real estate. So as interest rates come down, mortgages are more cost effective, you can buy a larger house, at a lower interest rate you can buy a nicer car, whatever it is.

Josh Sheluk:
So usually, a low or a decreasing interest rate, central bank rate, is going to be stimulative for the economy. So while these interest rates are lower, decreasing, we say we’re more in favor of stocks at that time than we would be of bonds.

Colin White:
Yeah. Then while they don’t set the longer term rates, that overnight rate does influence the rest of the market and the commentary that comes out with it also influences the rest of the market. So it’s not as if they have no influence over the rest of the curve. It’s just that it’s not as direct as it is here. And they do have other tools that they can deploy, which again, beyond the scope of this conversation.

Josh Sheluk:
Sure.

Colin White:
But Josh, you threw a phrase at me that I actually have been looking at as you’ve been talking, trying to figure out what it is, because I think I know what it is, but you know, the next thing you have on your list is unemployment about NAIRU. Net annualized, something something?

Josh Sheluk:
Yeah. Well, I’ll simplify it for everybody. There’s essentially what is called a neutral rate of unemployment in the economy. So this NAIRU that you’re talking about is a neutral way. It’s an acronym for the neutral rate of unemployment and there’s naturally some unemployment in an economy because you have people switching jobs all the time. People that leave a job, people that have seasonal jobs, people that are going to new jobs. So there’s some natural attrition there with an economy and people switching jobs.

Josh Sheluk:
So this is actually one that’s a little bit counterintuitive because you would say that well, high unemployment that’s bad for the economy. Yes, it is bad for the economy. But what high unemployment tells you, because we work and live in a cyclical world, high unemployment tells you that unemployment rate should be coming down. So when your unemployment rate is above this neutral rate of unemployment, the implication is that it should be coming down, things should be improving in the future. So that’s actually a time when you want to buy into more stocks when unemployment is high.

Josh Sheluk:
And when we have a period of time like today, where unemployment is quite low, counterintuitively, that’s a little bit negative for stocks. You might want to start de-risking your portfolio a little bit, because as things do, they move in cycles. And the next leg of that cycle, when unemployment is very, very low, is for unemployment to increase.

Colin White:
You could have just said neutral rate of unemployment, you didn’t have to use your fancy acronym, eh Josh?

Josh Sheluk:
This is the technical podcast, Colin. I can use whatever acronyms I want.

Colin White:
Oh yes, Josh unchained. Excellent. Because you’ve got another acronym here, this is great. I’m getting educated. You’re going so far into the weeds, you’re reminding me of stuff that I read in a book one time and don’t remember. Is the LEI? Like is this a trip to Hawaii, is that what we’re talking about now?

Josh Sheluk:
Yeah, that would be lovely. But no, we’re talking about LEIs, Colin, LEIs. Acronym for leading economic indicators.

Josh Sheluk:
So there are a number of indicators out there economically. You can look at things like unemployment, you can look at things like inflation, you can look at things like the stock market or inventories. There’s really dozens or probably hundreds by now of economic indicators, economic data points that are out there.

Josh Sheluk:
And some of them have proven to be leading. So the economic data point that you interpret and observe tends to be a little bit ahead of where the economy’s actually going. A good example is what’s called the purchasing manager’s index or PMI. So this is sort of a, it’s like a survey based on what managers at a manufacturing firm, for example, might think that they’re going to buy in the next little while. And if they’re quite positive, then that generally means that, hey, business conditions are pretty good, economically is pretty good, maybe we’re going to see some growth in the economy.

Josh Sheluk:
So we take this, it’s called a composite, it’s a combination of a number of leading economic indicators. And we try to see is this thing going in a positive direction or is it going in a negative direction? And if it’s going in a positive direction, we feel better about the economy, we feel better that we have growth coming down the pipe. And so we want to be a little bit more focused on the stock side of things, the growth part of our portfolios.

Colin White:
So next on the list is the relative valuations, stock valuations relative to bond valuations. And I guess another way of putting that is what the expected return is. Because again, at the end of the day, we’re looking for what a reasonable expectation of returns is by asset class, not just stocks and bonds. To Josh’s point earlier, it’s different areas within the stock market. And that is fundamentally, at the end of the day, that’s why we’re there is that where is the best potential return and weight the portfolios accordingly.

Josh Sheluk:
Yeah, exactly. I think you kind of hit the nail on the head there. We’re trying to assess where the best potential return is also considering risk along the way.

Josh Sheluk:
So when we talk about relative valuations, we can’t just look at stocks, say, and say, “Well, stocks are cheap.” Because what if bonds are cheaper? Why would I own cheap stocks when I can own cheaper bonds? Or vice versa, why would I own expensive bonds when I might own expensive stock?

Josh Sheluk:
So there’s always sort of an interplay between all of the different investments that are out there for you and you always have to be comparing one to the other and one relative to its history to try to assess, okay, what is my potential return? The more highly valued that an investment is today, the lower the expected return in the future and you can see this most overtly with bonds.

Josh Sheluk:
So if the interest rate on the bond is, say, 1%, that means that bond is very highly valued. It’s only going to give you a 1% rate of return. Whereas that bond comes down in price, maybe that interest rate is now 3%, that’s a pretty good indication of the return that you’re going to get on that bond. It’s a little bit more complicated with stocks or equities, but generally speaking, we always want to be assessing these two things and looking at the trade offs between one and the other.

Colin White:
Well, I guess it kind of tweaks with me right now, and maybe this is the point to bring it out. Because you alluded to it earlier, Josh, but when we talked about bonds, a lot of people go to government bonds. Canada bonds, U.S. bonds, but basically government issues. But there’s also corporate bonds out there, which are a wider basket of things that would have different characteristics and some higher rates of returns, higher levels of volatility, and then you can get into the private debt space and things.

Colin White:
So just to make sure people are not all thinking that the only option is to go to government bonds, we talk fixed income. It’s far more nuanced than that and they can be very attractive because the 1% or 2% interest rates on government and Canada bonds are not all that inspiring, but there are other places where you can go in that space to get a better expected, greater return, which is part of what we have to go digging for.

Colin White:
Oh, this is my favorite, Josh. You’re going to talk about heads and tails and inverted puppy dogs and all the world of technical analysis.

Josh Sheluk:
Technical analysis is really trying to get a gauge of sentiment and the general feeling for the market participants that are out there.

Josh Sheluk:
So when we look at the technical indicator that we use called the Bullish Percent Index, what it’s basically telling you is what percentage of stocks are going up and which percentage of stocks are going down. And again, counterintuitively, when you have a big, wide percentage of stocks that are decreasing in value, you want to be pretty bullish on things. You want to be pretty, maybe a little bit more aggressive and starting to increase your stock allocation.

Josh Sheluk:
Because usually people are overly pessimistic or overly optimistic. So when they’re overly pessimistic, the readings here are going to be quite negative and that might be a sign that, hey, again, things are cyclical. Things are going to turn higher from here.

Josh Sheluk:
And the other side is also true where you see this Bullish Percent Index running really, really high. Then maybe you want to take a couple stocks off the table or a little bit of allocation from your stocks because in the shorter term anyway, maybe this is an indication that people are a little bit overly optimistic on things and things need to come back to Earth a little bit.

Colin White:
Yeah, it’s interpreting what we think the sentiment really is out there and you have to infer. It’s not like we can get everybody to submit to a test or fill out a survey. People vote with their wallets and they vote with their activity in the markets and it’s about trying to turn that into an accurate representation of how they’re feeling at any moment in time. Emphasis on the work feeling, because again, that’s a dangerous thing.

Colin White:
And some people don’t even know how they’re feeling, they’re just acting. And those actions add up and can sometimes show us something. Like consumer confidence. That’s asking everybody how they feel, kind of. And it is one of the indicators that can matter.

Josh Sheluk:
Yeah. And you said we don’t give a survey out to everybody and ask them how they’re feeling, but actually we do. And that’s what consumer confidence is. It’s basically, here’s a survey, how are you feeling about things? And they ask a number of different questions and try to again, get sort of some type of composite or gauge on how collectively the population is feeling. People are feeling positive about things, they’re going to go out and buy that new car or that new boat or that new hovercraft or whatever it is. And if people are generally pessimistic on things… It’s sort of a feedback loop, if you’re pessimistic, you’re not going to buy as much. If you’re not going to buy as much, that’s going to hurt the economy and then you become more pessimistic.

Josh Sheluk:
So it can kind of spiral with this one. And that’s why if people are confident, consumers are confident, then we probably want to be a little bit more heavily weighted towards stocks and the opposite’s also true. If people are a little bit more negative on things or pessimistic, we want to probably shy away from stocks as much and maybe add some bonds to the portfolio.

Colin White:
Well, as a 55 year old in this country, I have never been asked my opinion. So I’m not sure how many people are asked or how often, but you know, maybe I’m not part of the target audience or something, who knows.

Josh Sheluk:
They only ask them.

Colin White:
Yeah, well maybe one day I can dream for something. Well, listen, I think that’s our seven indicators, but I think that it’s really important to kind of put this in context because even though these are seven specially chosen indicators that we think have some efficacy in telling us how to set things up, this is not a precise science. Because again, all of the data we’re looking at here is backward looking, it’s how things used to be. Therefore we’re trying to use that to predict going forward and that’s always fraught, you know?

Colin White:
So we use this information to go plus or minus a couple percentage points on waiting. You’re not going to see us use this information to go yeah, 60% cash, 40% U.S. equity. Because again, it’s not that precise. And if you begin to use nuanced information like that and expecting that kind of precision, you’re going to get disappointed eventually. There’s no special sauce here, there’s no way that we can with a great amount of confidence, predict the timing of moves. This just informs us as to, hey, we should lean into the wind this way a little bit, or we should lean a little bit that way.

Colin White:
Because ever since the first two-legged homo sapien on the planet looked up to the sky to try to figure out what the weather was going to be tomorrow, we’ve gathered information with the goal of predicting what was going to happen next. And we’ve had some success and we’ve had some not so success. The challenge or the important part is how much you believe in it and how you use that information. But this is a very comprehensive list of factors that you can consider in informing a decision on what expectations could be. Josh, do you have anything that we left out that you want to clean up?

Josh Sheluk:
Well, I would just say it’s not actually a very comprehensive list. It’s our comprehensive list, it’s everything that we look at, but it’s not to say that these are the only things that you can look at, it’s not to say that these are the absolute right things to look at. It’s just the ones that we’ve chosen to look at that we think, again, have some efficacy on being able to help us make decisions.

Josh Sheluk:
And I guess I would just say if you take anything away from this, it’s that having this type of structure around your decision making is extremely important. Without this type of structure, I think we’d be far less effective at actually making decisions that are going to pan out properly and rightly and profitably over the long term for our clients. So process is extremely important when it comes to investing. And I don’t know, I’m sure we’ve said that a lot of times over the last few technical podcasts, but it’s absolutely true.

Colin White:
You’re so modest. This is a lot to consider and you’re right, it’s not the only things, there’s all kinds of extraneous things to consider, but I think this is a very good list of some key things to consider. Unless we decide to add five more next time. And if we do, I promise we’ll have a follow up podcast to discuss five new things that we’re looking for, that we’re going to consider.

Josh Sheluk:
Next time on Barenaked Money, the 25 secondary factors to consider when making asset allocation changes.

Colin White:
And we’ll give out free pillows so you can listen to it.

Announcer:
This information has been prepared by White LeBlanc Wealth Planners, who is a portfolio manager for iA Private Wealth. Opinions expressed in this podcast are those of the portfolio manager only and do not necessarily reflect those of iA Private Wealth, Inc. iA Private Wealth, Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth, Inc. operates.

Colin White:
We’ve noticed something. It seems there are a lot of people who would rather try to figure out their lives with an online calculator than air your finances to a human. Stop doing that. You need to talk to someone who can help direct you, tell you where to start with what you’ve got to make the biggest impact on your future. You can’t figure that at DoIHaveEnoughCash.com, but you can figure it out by chatting with us. Call us. It’ll be okay. You’ll see.

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