Aptus Quarterly Market Update – Q2 2024

 

Transcript for Above Market Update Video

 

Derek

Hello, welcome. Derek here. I’ve got our head of equities, David Wagner, CFA. Our head of fixed income, John Luke Tyner, CFA. We’ve gotten into the habit of doing these before the quarter ends, just especially with 4th of July and everything coming up. We don’t want to try to tie the calendar up during that time, but I’m just going to go through some of the stuff. It’s obviously been a pretty wild quarter and it’s an election year. We’ve got earnings coming up. The Fed is not necessarily the imminent thing, but lots going on out there, so we just figured we’d go through. At the end, we’ll take some questions if you have any.

I’ll read a disclosure at the very beginning here and let the experts run through everything. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice, this material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus’ investment advisory services can be found in its form ADV part two, which is available upon request. Welcome guys. Thanks for joining.

John Luke

Thanks Derek. Fun to be here every quarter.

Dave

John Luke, can you see my screen in presentation mode?

John Luke

You’re good.

Dave

All right. Name’s Dave Wagner. Most of y’all know me. I head equities here at Aptus. But first and foremost, thank you so much for joining today’s call. I see a lot of familiar names here watching live and actually a few new ones, which is very cool. And so, since there’s a few new names out there, I think it’s always great to start these calls off on a positive note and actually sometimes, even talk about Aptus as a whole. And if you’ve watched some of our quarterly webinars, it’s about once a year, I try to remind a lot of our clients on our individual ethos of the entire company of Aptus because I truly believe that it’s something that we practice as a firm, as a whole, but we never truly say what our ethos is.

And some of these ethos could be that we don’t take any partner for granted. We try to develop every single relationship with our partners on every single day of the week, whether it’s through the different facets of our business, on trading, investments, the relations side of things, like really anything. Secondly, we don’t want to focus on being smarter than everyone else. We want to focus on creating long-lasting relationships and providing the best customer service in the business. And lastly, I think we all take our work very, very seriously here at Aptus, but we never want to take ourselves too serious. And I think that definitely shines through a few of our different personalities here. So hopefully, you all see a lot of these different characteristics that we try to show here at Aptus on a daily basis because I do think it’s something that everyone at Aptus believes in. It separates us from a lot of other people and it’s something that I hope to goodness that we’re just never going to give up, especially as we grow as a company, much like with the acquisition of LibertyFi this year.

So let’s jump right on it here. John Luke and I, we talked to a lot of different advisors and investors across really, the entire country. And we always should gauge where advisor consensus is or where maybe there’s some type of exuberance or even some type of misconception. And one phrase that I’ve really started to use here over the last week, it’s really started to resonate with some of our partners and it pays to be more patient than creative. And being creative in the investment world, it’s fun, it’s sexy, but it’s much harder to be patient. And right now, I think the best characteristic of any investor out there is to remain patient. And most people probably think that when an allocator tells them to be patient, that means that they allocator investor’s probably underperforming. Well, that actually couldn’t be more of the wrong aspect in our case because I think our off the shelf models, they’re outperformed by a few percent year to date. And the majority of our active ETFs are just absolutely kicking butt. And that’s the proper financial technical terms there.

So in this case that I’m talking about, that it pays more to be patient than creative, I’m talking about letting patience by letting the market work for you because when the market is in an uptrend, I think it’s very tempting for investors to try to get creative and really just call it market top, whether it’s the market top on the S&P500 as a whole or Nvidia or probably really, any of the magnificent six companies out there because it’s still been very much a concentrated market. But I just don’t want investors to really lose sight of the bigger picture here. It’s that you need to exercise patience and just let the market work for you because I know that client emotions, especially in an election year and on June 27th when we’re recording this, we have a first presidential election debate tonight, and that really kicks off, I’d at least say, the emotional roller coaster of a lot of our clients throughout the entire election cycle.

But even stepping back, there’s always going to be a wall of worry for investors to climb. So I think it’s always great to go over some of the good, Some of the bullish aspects that we’re currently witnessing in that market. And it all starts with earnings. Actually, earnings have been very strong and it’s a pet peeve of mine when people say that, “Hey, earnings have been resilient.” It simply should say that earnings have been strong because there’s been a lot of tailwinds both on the consumer and on the business spending side. The consumer itself, it’s never been this strong ever, whether you look at it from an absolute standpoint or a relative standpoint.

And then you could look at the amount of CapEx spend by companies, especially over this past quarter on the CapEx revisions. Obviously, this is honed in around on the AI space, but it’s absolutely wild. But investors forget that every single dollar invested in CapEx from a company, it’s going to be a dollar of revenue for another company. I think you look at the market and you have to talk about AI itself as being a bullish reason for the recent market rally of close to like 34% off the October 27th low. But I don’t want to pontificate that AI or this technology is going to be revolutionary or evolutionary. But what I can say is that for the first time in about 20 years, we have a technology that legitimately increases our own domestic economy’s chance of increasing productivity. And that’s just something that I never want to bet against.

AI and the trade, it has an absolute great trend. And our head the equity trader, our head actually, overall trader here, Mark Allen, he has a saying that trend is friend and AI and stocks, it has a trend. So let it be your friend. And by simply owning our structure of our allocation of more stocks, less bonds, or remain risk neutral, you have a very efficient way to actually benefit from this technology without having to risk by picking the correct winners or not owning some of the AI charlatans that are out there. Because I truly believe that there’s going to be a few winners in the space and a lot of losers. So there’s a lot of good out there in the market. If you look at the macroeconomic data, at the end of the day, unless you’re in the depths of some type of recession or at the very start of a new business cycle, there’s always going to be data that conforms to your personal investment thesis.

And it’s our job here at Aptus I think, to really educate clients and investors, what is noise and what is actually material? What is material for the market to continue to drive higher or lower into the future? And that’s why at the end of this webinar, John Luke and I, we’re going to have a section where we hit on three topics that really resonate with our client base that we think needs to be the focal point of our client base. Because at the end of the day, you need to focus on what you can control and prepare or hedge out for what you cannot control. So we’ll start on those facts section. We’re going to talk, I think it’s like the market and elections, it’s going to be talk about, this is the biggest topic I actually think that we’re going to talk about. It’s maybe that the investor hurdle rate is much higher than what most investors think. And then we’re going to talk about just market valuations.

But to end this equity market commentary, I’m going to tell you that the biggest thing I’m focusing on right now, it’s going to be growth. Earnings growth, revenue growth, really any and all type of growth because at the end of the day, if there’s some type of kryptonite for this market rally, it’s going to come in the form of slowing or negative growth. And this is something that I’m highly convicted in because I truly believe that inflation at 3%, it’s not a huge threat to the market or the economy itself, but more so the Fed’s reaction function to how it handles slowing growth. And obviously JL is going to talk more about the Fed and more macro, but I really truly believe that the Fed wants to cut rates right now.

The rest of the world has already started to do that over the past few weeks. And if you look around the globe, I think the rest of the world’s really already seen or is currently in some type of slowdown because at the end of the day, to gauge this perpetual argument that we’re having in the market of hard landing versus a soft landing, the debate’s going to be great and engaged by what the Fed does with rates. If rates are slashed lower, substantially slashed lower, that means that we’ve probably had some type of hard landing and that the market’s in some type of recession.

But the preferred path by the Fed is basically cutting rates very, very slowly to help mitigate the slowing growth there. That’s the soft landing that we’re looking for. It’s really just trying to rejuvenate the market or probably keep that Goldilocks market environment that we’re currently in right now. But as you can see, I’m the equity guy here at Aptus and I’m probably talking more rates and Fed than I normally do, but that’s because that’s what the market’s focusing on right now. And at the end of the day, we all know that the bond guys like John Luke are much smarter than the equity guys like me. So I’ll probably just pass it off to John Luke to talk a little bit more of what we’re seeing from inflation, the Fed and just the bond market as a whole, because I think it’s such a fascinating topic.

John Luke

Yeah, excellent job. Thanks Dave. Yeah. So, we thought that really, this was a nice chart to start with and it just shows that the pain that we’ve seen in the bond market since August of 2020 has been excruciating for most investors that stuck with a 60/40 type of profile and held bonds. And one of the biggest things that I think sticks out is, if you bought bonds in August of 2020, the price return is down roughly just shy of 20%. And so to put that in context, in order to paper over the losses in terms of your price degradation, it’s going to take, if yields stayed exactly where they are right now, there’s no price movement, no rate movements, over four years in order to paper over those losses. And that’s extraordinary. And I think to make it worse, given that we don’t really expect significant decline in interest rates and we expect that even if the Fed does cut rates, that it’s pretty likely longer term rates stay more elevated, that this trend of consecutive months of bonds being in the hole is likely to extend significant into the future.

So borrowing some kind of crazy move and yields lower. This number I think, could maybe even double from where it is now in terms of reality before bonds have dug out of the hole. And to really preface this top left chart, Dave and I go back and forth with some trivia questions. So Dave, as far as stock bond correlation goes, it’s obviously been a huge topic and something we’ve really focused on a huge part of the story at Aptus. If you had to guess for the year, have bonds drawdown been close to as big as the drawdown that we’ve seen in stocks? So for relative stocks, had about a five and a half percent drawdown from peak to trough predominantly in April.

Dave

I would say that I do believe that I know the answer to this question, first. I think it would surprise a lot of people. And actually if you actually just go back to the end of the first quarter of this year, fixed income actually had a greater peak to trough drawdown year to date than stocks itself. And now, you fast-forward three months to today, I think that number between the bonds peak to trough drawdown and the stocks via S&P500 peak to trough drawdown is almost in parity. I think fixed income’s down like 4%, peak to trough stocks are down what you say, 5.5%? The takeaway there is that you can still have a pretty substantial drawdown in fixed income even after you’re like 2022, but more importantly, you’re getting some positive correlation there to the downside.

John Luke

Yeah. And the extra credit answer was on TLT, it’s higher. So longer term bonds have certainly been more volatile, but one of the biggest things we’ve talked about as part of our investment approach and philosophy and building portfolios is you’ve got to have components of the portfolio that can ying and yang together properly. And the correlation of stocks and bonds has increased dramatically in a bad way for asset allocators. And with a positive stock bond correlation, basically, what it does is raises the entire variance or the volatility of your aggregate portfolio. And if you look at how portfolios from a volatility perspective acted from 2000 to say 2020 compared to how they’ve acted since 2020 and really post COVID in August, the chart that we started with, you’ve got a 40 or 50% increase in volatility for a 60/40 portfolio. And it just shows the power of when bond yields aren’t always declining and when you’ve got sticky inflation, it really creates problems for asset allocations.

And as far as how to solve for that, well, we believe you have to have other things in the portfolio like volatility as an asset class. So all in all, to start with that, which I think is going to be one of the biggest drivers of portfolio construction and really bonds in general moving forward, you continue to see that play out. For the quarter, fixed income was relatively flat, had slightly positive, but you can bifurcate the move into two sides. For the first couple weeks of April, you had a continuation of bad inflation data. You had a realization by the market that maybe we weren’t going to get seven rate cuts in 2024 and maybe it was zero, maybe it was one. And you saw bonds sell off drastically and yields rise back up near the highs.

Luckily, some pretty solid data on the inflation front and a little bit of softening on the economic side brought yields back lower. So you look at the beginning and you look at the end of the quarter and it was pretty boring, but not really, the road to get there was quite interesting. On the second chart, which I think also will continue to be a large driver to moving yields is the amount of debt outstanding. We got a nice report last week, well, not really nice, but the CBOE came out with a report talking about the deficit and the move in the deficit was substantially higher than what was estimated at the beginning of the year. And so basically, the chart on the right is just showing effectively, the average yield on outstanding US treasury debt. And as yields have stayed higher for longer, it’s continually risen, it’s sitting at about 3.2%. You’ve obviously heard, if you watch any news, that interest expense is now greater than defense spending.

So I do caution that as we continue the path of this fiscal spending, I’ve called it the drunken sailor spending, approach that we’re taking, I would not be surprised if we continue to see some comeback of the bond vigilante folk in terms of who’s going to buy all of this debt. Coming through to the inflation picture, we continue to see improvements in inflation, the first couple months of the year were a little bit more choppy than I think most hoped, especially if you looked at the service inflation data. The shelter inflation data continues to be pretty robust, but we’re seeing improvements and I think that ultimately, the question that we continue to ask is, is the 2% target by the Fed like the God’s truth or is it two point something and they can live with it?

And I think what they’ve continued to communicate in maybe not a direct way but around the edges is that two point something’s probably acceptable as long as inflation’s not running away in terms of expectations for future inflation. And so essentially, my vision is that the Fed is going to allow inflation to really slowly decline. And you saw that with their estimate for the PCE inflation for the end of the year, no improvements between now and then, but they’re still going to potentially cut rates or at least that’s what they’re penciling in. So you put it all together, the goods inflation piece of the pie has certainly helped. The immaculate disinflation as a lot have called it, has played out. We’ve gone from nine to a little less than three. You’ve got sticky inflation on the services side, you’ve got sticky inflation on the shelter side and those are just going to have to pan out over time.

But I think that, like Dave said, the ultimate reality is the Fed wants to cut rates. If it was up to them, they would’ve probably already cut by now. And I think that’s what the market was really hoping for coming into the year. But you put that aside and you keep in mind that the Fed and the market were illustrating that in 2024, we were going to get a slew of cuts. The market was pricing in up to seven cuts at one point, at the beginning of the year. And to think that how well the markets performed relative to how those cuts have been substantially taken out of the market has just shown the resilience of the consumer. It’s shown the resilience of the economy and it’s shown a lot of things that maybe rates weren’t as high or as restrictive as what we would’ve initially thought.

You fast or you rewind a couple of years ago, and if anyone said that the Fed fund rate was going to be sitting at five and a half, everyone will be pulling their hair out saying that the market could not tolerate that at all. And lo and behold, we’re here. And so, overall, we continue to think that while nominal yields are higher, that cost of living is obviously going up, you see money supply growth, you see deficits into the future that the government’s broadcasting. And I’ve tried to write a lot about that. And it just puts the hurdle rate for fixed income higher than what nominal yields are currently. And when we think about compounding capital, when you think about what matters, you think about longevity, well, real returns matter and you put it to the side and we’ve got a couple other charts. I think that the next one that we’ve got… You want to skip down to 12 there. I’ll hit on this one and then I’ll hush.

But the asset allocation woes, this is a steady Eddie that we always have out showing real growth of the S&P versus cash, and it’s obviously a big decline. But the other important thing I think is, if you look back over the past 20 years and you look at where inflation is, which is the red dotted line, you look at the performance of the Ag and you look at the performance of stocks, and it’s just absolutely bonkers to me that your real return on bonds and people have been okay accepting those returns have been basically in line with inflation. And that’s certificate of confiscation as I like to say. So, hop in, Dave.

Dave

John Luke, this is one of the biggest topics that a whole lot of people are just not mentioning or talking about because for the first time, as you said, John Luke, since 2007, our nominal yields, we haven’t had yields this high since 2007, let’s just call it give or take, 4.5, 5%. And we’ve had to say it here after that people think in terms of nominal, but they eat real returns. So let’s just say nominal returns are at 5%, core PCE or just a CPI inflation is at 3%. So you get a nominal minus your inflation to get your real rate of return from a yield perspective. So it’s five minus three is 2%. So a lot of people have been thinking that their hurdle rate from an investment standpoint versus treasuries or fixed income is 2%, right? And I just think that what you’re talking about right now, John Luke, that just woefully falls short of what the actual hurdle rate is out there in the market.

And JD, our founder CIO, had a great piece from a monthly perspective, I think it was just last month, really walking through in a very palatable way to talk about, hey, that real rate, that real yield of 2%, that is much lower than what your actual hurdle rate should be, and just try to get a few more voices. Actually, I’ll just keep going here, John Luke. If 2% real rate is not the proper hurdle rate, what is that proper hurdle rate that we should be looking at? And it’s probably close to the increase in deficit spend because if you think about the budget, it’s never balanced. There’s always some type of deficit. And over the past year or so, we’ve seen the increase of the budget deficit increased by about 7%. And for the government to balance their budget, they basically have to issue treasuries of about 7% there to increase or to at least negate that deficit windfall itself.

So what happens throughout the schematics of the government issuing treasuries and the Fed is basically the government’s issuing treasuries and there’s basically a buyer of it, and that’s going to be the Fed itself. And through the Fed, you’re getting the increase in the money supply said another way, the M2 itself. So what this chart on the left is showing us here is that basically, through the degradation of your purchasing power by the increase of the money supply, it’s substantially larger than just the real rate of return or the real yield over longer periods of time. So if the government is diluting your money supply by 7% per year, that almost means that your hurdle rate is closer to 7%. It’s not that 2% itself. And at the basis of why everyone invests in T-0, time now, it’s not just to maintain their lifestyle in the future, it’s to make it much better, to have a better lifestyle in the future.

And if you’re just pegging your hurdle rate to be that real rate of yield of 2%, you can be woefully falling short from a purchasing power perspective of your client’s ability to increase their lifestyle into the future. And what we do at our allocation level is very important. Everyone’s heard our saying, it’s more stocks, less bonds, risk neutral. The fact of owning more stocks and on hitching the trailer on hitching the wagon of drag to performance that fixed income provides to you because it’s only giving you that 2% real rate is really one of the best ways to negate this problem, which is called longevity risk and a lot of allocations itself.

John Luke

Yeah. And two big things that I think we shouldn’t brush through is, number one, taxes on bonds are going to make that real return even lower because it’s taxed unfavorably. And then the second piece would be related to that correlation benefit of, if you’re getting good breaks from bonds in an allocation, then maybe you’re willing to have a little bit of a governor on the equity side. But if the correlation is positive, and you saw a prime example in April where the S&P was down five and bonds were down almost two and a half, that combination is painful. And effectively, if you’re going to govern your upside, you’ve got to have good breaks on the downside. And I think that it’s obvious that it’s going to be a struggle for bonds to really give you that.

Derek

I think that’s a key point right there is just the, not that we’re making any prediction on bonds, you’ve talked about some of the challenges that are there, but just that it’s not a reliable. You can’t rely on it to do the job that it did for a period of time because that period of time, that’s not through history that bonds have always served that role. They just happened to do it during the careers of a lot of us and a lot of advisors and a lot of clients, frankly. So everyone benefited, but in general, you can’t look at bonds and say that they are absolutely going to do what you need them to do if stocks take a tailspin. And that’s where I think, the use of hedges and some of the other things we do at an allocation standpoint can be helpful.

Dave

That’s just such important because everyone wants to talk about T-Bill and Chill. They wanted to do it back in August, September and October of last year and see how that worked out for them when the S&P 500’s up 34% since the 1027 bottom. Even right now, we’re seeing that conversation really start to populate again right now just because the market has had such kind of a crazy run. But our thoughts and thesis from a structural standpoint still don’t change even after a market rally here. So let’s move on to the next topic that I’ve had a lot of questions about here, more recently, especially as we head into the second half of this year. We know one of the best things that Aptus does is try to attack the behavioral gap that clients have, more fully to make sure that they remain invested over longer periods of time and just take out the volatility of their emotions in regards to their investments.

And there’s no topic in my opinion that is more volatile from an emotional standpoint than politics. Our country’s split 50/50 between Republicans and Democrats, but no matter whether you’re a Democrat or Republican and your views on the market reviews on fiscal or monetary policy, social policy, the market and election cycles, people believe that there’s a lot more volatility out in the market leading into an election. And while I would say that is correct, you really start to see the VIX, the market’s measure of volatility really start to tick up really after Labor Day. That’s when the market and clients really start to focus on the election itself. But we do have a presidential debate tonight here on June 27th, but I think a misnomer or misconception out there in the market is that during the fourth year of an election cycle, so basically the reelection or open election year, that there’s more volatility and that there’s poor market returns.

Well, that couldn’t be more wrong whatsoever, that here’s a wild side, it’s a chart of the left sided. It goes back to 1944, whenever a president is running for reelection, which we currently have right now with incumbent current president Joe Biden, the S&P 500 has never ended that year in negative territory. So let me say that again. Since 1944 when there’s an incumbent running for reelection, the market has never been negative. Not only that, not only has the market not been negative, it’s had an average annualized return during those years of 16%. That’s 2x greater than the average return of the S&P 500 dating back to 1926 if you include every single year. So in fact, your initial inclination may tell you that, hey, the market’s more volatile this year in a reelection year, the market doesn’t have as great returns in the election year. That’s a myth and it’s so easy to debunk.

But one thing that we’re looking at from a market perspective is that the market does try to figure out what the outcome of election is going to be. And two of the largest things that you can look at to help [inaudible 00:28:43] the outcome of the election is going to be, the first is going to be recession. If there’s ever a recession in the two years preceding an election year, so basing in year three or year four of an election, the incumbent or the incumbent party has not been reelected whatsoever. The second thing to look at when you’re looking at the S&P 500 and the market and its potential [inaudible 00:29:08] the outcome of the election itself is, if you look at the 45 days heading into election, if the market is positive, the incumbent tends to get reelected. If the market is negative, the incumbent or incumbent party tends to not get reelected.

So there is some tidbits that you can look at to the market to figure out what’s going to happen in the election closer to the election date itself. But if you zoom out and try to have a pragmatic view on what’s going on in the market during election years, it just doesn’t matter. In fact, it actually does matter because you get a 2x annualized average return better than the average year, you get an average return to the S&P 500 of 16% when the markets had average annualized returns closer to 8% itself. So John Luke, you asked me a trivia question earlier. I got one for you. I think you know this one. Obviously, I mentioned that the fourth year of an election cycle has an average annualized return of the incumbents running for reelection of 16%. Let’s just gauge the market election cycle. There’s four years in election cycle. What years of that election cycle, John Luke, do you think actually have the best return measured by the S&P 500?

John Luke

Yeah. Well, I think the easy guess would be four, but I’m going to go with three just because they’re priming, getting ready for that year four and the campaigning. And then you look at last year, and that’s basically what you saw too.

Dave

Yeah, you’re exactly correct. It’s like the referendums that an incoming president has. When a president gets elected, the referendums, they really try to put in place in the market, whether it’s from a regulatory aspect, a social aspect, it really inhibits market returns in the first two years in the election cycle. So you’re exactly correct, John. The best year during the market election cycle via measured by the S&P 500, it goes year three of the election cycle is the best year. Year four is the second-best, year two is the third best, and year one is actually the worst year on average during a presidential election cycle via the S&P 500. And it’s pretty obvious, John Luke. You probably have a slew to lift in your mind, John Luke, and I’ll let you talk about that, of the liquidity that’s been injected into the market, not just this year, but last year that’s really started to insulate market returns, whether it’s from an earnings profile standpoint or even from a valuation perspective.

John Luke

Yeah, it’s a laundry list. Fiscal policy has been pretty loose, 7% deficits. The CBOE or CBO Congressional Budget Office, which is supposedly nonpartisan, is basically saying 7% deficits for the next 10 years. But you’ve had student loan relief, you’ve had the SPR drains, you’ve had the infrastructure spending and some of the post COVID stimulus that’s basically a trickle into the economy. You’ve got, which one point that we haven’t touched on, but I think is important is at 5.5% rates, who’s the beneficiary of that income? And it’s the largest companies in the country. Think about the balance sheets of the MAG 6. I like how you did that today, making sure to take Tesla out, but the Mag 6 and the wealthiest Americans are getting a five to 6% clip on their savings. And so there’s so many things that I think just continue to point towards the inflationary backdrop that I don’t even think we can fathom what we could experience the next 10 years.

And it goes back to the points on the asset allocation side of, probably pretty hard to get a drawdown whenever you’ve got the household net worth at all time highs, when you’ve got fiscal deficits at 7%, it’s pointing to a new cycle that we haven’t seen in the last 20 years. And I think that if we have a time machine and we come back and look at the decisions that we’re making today in the portfolios that the impact that we’re going to drive for our clients and for our shareholders is going to make a big difference in their life, and that just goes through some of the conviction of how we’re positioned in the portfolios. Because we talk about it, it’s funny, but at the end of the day, there’s a real debasement going on with your dollar and your client’s dollar and think about the beneficiary of who benefits from inflation?

Well, it’s governments and they’re incentivized to do it long-term because it’s the easy way out. You can’t let stuff burn. We’ve basically shunned having that type of environment and the more debt that they have just means the more things are going to cost, the more that the dollar’s going to be debased over time. And just so important that the asset allocation mix is innovative for these times.

Derek

Typically, when you hear people talk about deficits growing and foot out, a gloom and doom type of scenario is usually accompanying that. And really, what we’ve said is, I think the playbook in the past few years is pretty clear that you can’t just stick your assets in commodities or tips or these other inflation protection type vehicles, companies, US companies in particular still have a lot of pricing power, which this feeds into your world, Dave, but companies that can raise their profits, that’s the protection, that’s the inflation protection which feeds into, does that make stocks more expensive? Well, not if they can grow their earnings at the same rate or more.

John Luke

Yeah. I love being the bond guy that tells you don’t own bonds.

Derek

Yeah.

Dave

I’ve never heard you say that one, John Luke, I love it. But you’re exactly right, Derek, valuations are high right now, but we do have a saying here at Aptus is that price is what you pay and value is what you get. And whether you’re looking our compounder sleeves or a lot of the sleeves that we own, the other SMAs that we run, really embodies that aspect. Companies that have pricing in elasticity, pricing, power, long runways of growth to really combat or utilize inflation to their benefit as a lever to drive not just revenue growth but earnings growth itself. And throughout my career of investing, I feel like 99% of the time, people believe that the market is expensive, which in my mind, in a vacuum, is simply impossible because valuation is mean reverting. It’s either in the top 50% of expensive or below, so it can’t always be expensive.

And so I think it’s so important to try to educate and teach investors on how to look at valuation the proper way because a lot of people would always state that, “Hey, the market’s trading at 22 times 2024 earnings.” Which it is. It’s trading at 22.4 times 2024 earnings. It’s actually closer to 19 times when you actually go out to 2025 earnings. And many people who have listened to me talk for quite some time is that the market finally starts to shift their focus on earnings for current year until the next year, starting in June, July and August of the year, meaning that the market rate now that we’re in the summer, June, July, or August, you’re going to start focusing on earnings in 2025 now. So I actually like to look at the 2025 measure for valuation, putting the S&P at closer to 19 times, but even that 19 times, everyone fully believes that’s very expensive because if you compare it to the valuation back in the ‘1980s, when the mark was trading closer to 12 times or a little lower than that, you’re trading almost at 100% premium.

But it’s just such a wrong way to look at valuation in my mind. And let’s try to break down in the most simplistic form. Let’s say that we have two stocks, stock A and stock B, they do the exact same thing, same business line, same growth trajectory, same everything, but only one thing is different and it’s going to be profit margin. Let’s just say that stock A has a profit margin of about 8%. Stock B has a profit margin closer to 17.5%. If I ask anyone on this call, does stock A or stock B have a higher valuation? And everyone’s going to raise their hand on stock B because they do the exact same thing. Stock B just has a higher profit margin over double the profit margin of stock ed and everyone would be correct. And that’s just such a mainstay answer that everyone is always going to get correct.

But when you transcribe that to the S&P 500 as a whole, they don’t get this correct because currently right now, the next 12 months operating margin for the S&P 500 is 17.5%. Back in 1980, 44 years ago, the operating margin was closer to 8%. So why are we comparing today’s valuation of the market to a market that had a substantially different margin profile and a constituents base 44 years ago? It’s something that we shouldn’t be doing. And what this chart on the top is basically showing us, how our SAP 500 index has evolved over time from a CapEx heavy, a hard asset heavy balance sheet to be more of on the innovative side of tech with asset light balance sheet and higher margins.

A wild statistic that I always talk about is if you look at the aggregate balance sheet of all the companies in the S&P 500 back in 1984, about 90% of the assets on the balance sheets were tangible assets. Fast-forward to today, if you aggregate all the balance sheets of the companies in the S&P 500, 95% of the assets on the balance sheets are intangible assets. That just shows how our economy and our market has evolved over time. So we shouldn’t be comparing today’s valuation to the valuation of yester-years.

Derek

There was also that graphic going around too. Cashflow, same thing. Operating cashflow is like straight up 45 degree angle to the northeast of how markets have changed over the past couple of decades. So the valuation’s important based on that.

Dave

Well, you can almost take that a step further there, Derek, let’s just not look at the domestic market relative to our profile 40, 44 years ago. You could still compare it to international markets as a whole. International markets have historically traded an 8% discount to the S&P 500, and now, you’re actually closer to a 50% discount of international markets relative to domestic US markets. And for about 10 years, investors have always been trying to call the top, “Hey, I want to go overweight international solely because of valuation.” But we know it’s whether a stock investor or invest in allocations itself via asset classing, valuation doesn’t mean anything if there isn’t some type of catalyst to create mean reversion over longer periods of time. And that’s just something that international markets haven’t had because they remain more service oriented on the construction within the constituents of their portfolio or more asset heavy than what the US has itself.

So what the chart actually is showing here on the bottom that I haven’t talked about, it’s basically just taking the sector exposure of the S&P 500 and mirroring the sector exposure and weighting that of the international markets. And that would tell you that the S&P 500 only trades, pardon me, at a 12% premium to international markets. And if you take a step further, the amount of growth that we’ve had here domestically relative to internationals, almost two and a half to three times greater than what you’re seeing international. So if you re-weight the constituents of international and domestic benchmarks that have the same sector exposure, maybe a 12% valuation premium of US markets to international markets is probably merited due to the growth profile, not just over the past five, 10 years of the US but probably looking through the windshield five, 10 years down the road given the construction that we’re more asset light, heavy margin and more technologically innovation driven than other economies in the world.

So let’s wrap this up. And this is something we do on every quarterly webinar. We go on a quick round table from myself to John Luke and to [inaudible 00:41:49], try to figure out what’s something that’s out of focus for a lot of advisors. What’s one thing that they’re not thinking of? What’s a positive and what’s a negative that’s been on our mind lately, maybe where people should start focusing on that? Is it noise that might be material or at least somewhere that we think should get some garner more recognition out there in the market. So John Luke, I’ll let you start. What’s your pro and what’s your con?

John Luke

Yeah. So the definite con is inflation being and continuing to be more sticky. If it’s hanging out in the three point something range, I think the Fed’s going to be uncomfortable with that. And that could create the environment where rates are held higher and there’s just more potential for negative impacts to the economy. That’s got to be the negative. And then I think the positive is you continue to see employment be resilient, you continue to see wage pressures to be strong and all time highs on net worths. And that has so far led to the consumer continuing this resilience and think about what’s the steam engine of the US economy and it’s the consumer. Until you take him out, it’s going to be really difficult to see damage. So I think to sum it up, that’s how I would… Unless you see employment really take a rise or unless you see some lack of further progress on inflation, I think we could continue to be in a good spot for risk assets.

Dave

I totally get that. I’ll go next. I think my positive and negative… My negative is always going to be slowing growth. If growth slows, that’s the kryptonite to a market rally or at least, the expectation that growth is going to slow. And if you look at a lot of the targets for 2025 earnings growth, which is about 10 or 11% right now, a lot of it’s coming off the back of margin, not all AI driven margin, but I really want to make sure that stocks and companies really start to see some type of top line growth that not all the growth and earnings per share is going to come from the margin profile expanding, that to get that really operating leverage on the margin side of things, you’re going to have to get some type of top line revenue growth. And that’s just something that’s been pretty benign here over the past three or four quarters that I think could catch the market off guard if that doesn’t continue. That if margin expansion on the EPS story is necessary from operating leverage from revenue growth, that may not happen.

But again, the rally killer here is going to be growth. I think the positive I have here is something that not many people are focusing on. The beauty of our allocations are that we don’t have to make calls on the market or tilts to be overweight, domestic versus international, this or that. But I think where my view, if I had to make a tilt that’s out of consensus, and this is coming from the small cap guy too, that you could see the MAG 7 continuing to grow earnings much better than anticipated, or pardon me, let me rephrase that. The MAG 6 grow earnings more than what you may expect and it all comes down to CapEx. And obviously, these magnificent seven companies, they got to execute their CapEx and have that turn into some type of profitability or revenue growth. So some type of return on investments.

But if you look at the amount of CapEx spend for this year for the MAG 7 companies, it’s $328 billion, right? A lot of these companies like Google, Apple, Microsoft, they have so much money on their balance sheets that are clipping 5% right now, plus they are a great operating leverage business, has great margin and just operating cashflow itself that they can actually reinvest into themselves and reinvest into the markets where they can invest that $328 billion into CapEx this year. And if you look at that $328 billion of CapEx that aggregates about 60% of the free cash flow by the Mag 7 goes into CapEx. And if you take that in relation to the remaining 493 stocks, that $328 billion is three times greater than the aggregate R&D CapEx spend by the remaining 493.

So I don’t want to call this a winner take all market, but when you can invest that much capital efficiently, because that’s the big difference between the market today and the market back during the.com bubble back in ’99 and ‘2000. A lot of those companies back then were taking on debt and raising equity to finance growth. Nowadays, they’re actually just using cashflow, retained earnings, earnings from income from the cashing on their balance sheets, operating cashflow. That’s the difference between now and then. So I do think that this market could continue to be led by some of the higher concentration or the higher mega cap names than the S&P 500.

John Luke

But to extend the comment that you said earlier, a dollar of their CapEx is a dollar of revenue to someone else. So as long as it’s not directly just paid around to each other, then the rest of the market should see some benefit.

Dave

And you’re seeing that with earnings moving forward with smaller caps, that small caps and large caps have an earnings inflection where they hit equilibrium in the first quarter of next year. I really hope to see that happening. So you get the broadening out of the market because I think that can obviously drive the market even higher than where we are today.

John Luke

Yeah. Agree.

Derek

I do think we did have a question. I do want to open it up in case people do have questions. There’s a question about what’s noise, what’s material? Which to me is really important as advisors are going through, it’s quarter end. This is when a lot of advisors have their meetings in the first part of the quarter and clients always have a long list no matter what the market’s doing, they have a long list of things to be worried about, especially in an election year, especially if they watch the news a lot. So I think the question is, can you put together a slide relating to that? And the answer is yes, I think that’s a great idea, but maybe you guys off the cuff can just think of some of the things that, really what is not material, what seems to be important that really hasn’t been and probably isn’t? I don’t know if you guys have any thoughts on that>

Dave

John Luke, I’ll let you go first, but in our quarterly deck that will be coming out day one. So Monday next week, July 1st, I guess Monday’s the first, we do have this good and the bad ugly that we always put out, and that’s like our rifle approach to what we should be focusing on, what could go really well and what could go poorly with the good, the bad, the ugly. We also have a secondary slide in there that says, “Hey, let’s keep things in perspective,” and it’s going to have a list of really good things that are going on and some really not so good things that are going on. And that can be the north star to showing clients on what they should be focusing on so they can cancel out that noise.

John Luke

Yeah. And I’ll hit on four of really the biggest things that I’m focused on. And then I’ve got to include one Atus wide thought, which happens to be the last slide on our presentation. But at the first level, it’s growth. Just like Dave said, can the companies continue to grow and have the earnings resilience that we’ve seen? And obviously, there’s a bunch of drivers, whether it’s top line, whether it’s margin, whether it’s buybacks, whether it’s acquisitions that can help move the needle there. Core inflation is the second biggest. Maybe the combination core inflation and the employment markets would be the top two or three in terms of impact. If core inflation doesn’t slow down, that creates problems for the Fed. So it’s very important to watch that and even think about the impact of shelter inflation because it is a lagging indicator of at what point does the Fed look past that and look to the future and expect that shelter prices will move lower or at least stop going up.

The employment side is super important because the consumer piece, if we do see marginal increases in unemployment, I think that that would preempt the Fed to act more quickly. And then the other piece is, if we do see degradation in employment, if we do see impacts of slower inflation that the Fed will act. And I think they’ve made that pretty clear. So whether it’s them cutting slowly to essentially not be overly restrictive or they’re cutting more aggressive, the Fed put I think, is actually more alive than we’ve seen the last several years. And then to go to slide 18 there, which just shows the cost of hedging. And I think those other topics are important. They’re the newsworthy pieces, but this vol is cheap piece, I think, is pretty important for their portfolios, especially if they’re invested using some of the Aptus exposures where the cost to protect the portfolio is extremely inexpensive right now.

It continues to make basically the cheapest cost of protection that we’ve seen over and over, month after month. We’re repeating the same line because it gets cheaper. And so to know that we’re buying insurance effectively in their portfolios while the sun’s shining outside and we’re prepared for a crazy election cycle, we’re prepared for geopolitical issues that could pop up. We’re prepared for the unknown, I think just lets us sleep at night to know that we’ve got the protection in the portfolio, that’s a hedge against the market that if things go crazy, not only do we have the protection, but we’ve bought it at really ideal times to be really effective if markets do become wobbly.

Dave

I think this slide is the greatest slide to show right now. The amount of conviction that all of us have here at Aptus in what we’re doing right now, I would say one of our main phrases is, own more stocks, less bonds while remaining risk neutral. Well, the linchpin to all of this is owning vol as an asset class and owning vol as an asset class is like owning insurance. And in a world where insurance inflation is running rampant, whether it’s on cars, homes or whatever, vol insurance on the market itself hasn’t been this cheap basically since 2007.

So I know I’m not allowed to talk about performance, but I love the performance of our allocations off the shelf asset allocations. Every single one of our active ETFs, they’re absolutely doing so great. Now, I’m so excited along with the rest of our team is, but just this slide right here is the epitome of why we have so much conviction moving forward into the future in case something happens that we can be so prepared for. Whatever can be the Black Swan event that we see in the future is that no matter what, we’re going to be prepared for it.

Derek

Awesome. Any other final thoughts? We’re 50 minutes in and probably want to wrap. You guys have done a really good job of really covering all the topics. And I think the question that came in about what matters and what doesn’t is really relevant because it does seem like a lot of clients are just happy to get that CD or that T-Bill something that gives them 5%. And I think everybody knows that number probably goes away. It adds reinvestment risk, it adds longevity risk. There’s a lot of components to that. And I think your job is really to help advisors educate clients on the benefits of owning. We just think of it as equities with guardrails. Having the ability to stay invested in these profitable companies, knowing that you do have protection in place. So I don’t know what you have to add on that, but to me, that’s the focus of the next couple of weeks is to help put more content out that helps advisors in those conversations.

John Luke

Thanks guys for hopping on and appreciate helping organize, Derek. As always, if anyone has any questions, follow-ups, thoughts, recommendations, please share. We’re open ears. I’m sure we’ll talk to a lot of you here in the next couple of weeks as well. And if we don’t talk before, have a great 4th of July.

Derek

Yeah, happy fourth everyone. We’ll send this out. If you’re registered, we’ll make sure that this gets in your hands along with the slides. So appreciate you spending the time with us and talk to you all soon.

Dave

God bless America.

 

 

Disclosure

The opinions expressed during this Webinar are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.  More information about Aptus investment advisory services can be found in its Form ADV Part 2, which is available upon request. ACA-2406-26.