Our founding partners, Matthew Davis and Hannah Boundy, sat down for an informal conversation about what we're seeing in the markets and what that means for Sherwood.
Hannah Boundy Hello, everyone. Happy New Year, and welcome to 2024. Today, Matt and I just wanted to have a little bit of an informal conversation about what it looks like for us every January when we sit down and review. We go through last year's data and go through our economic outlook for the next year. And this is something that we have done for a long time. For those of you who do not know, Matt and I have worked together for over a decade at this point. He was actually my first boss, and so this is a habit that we have been doing for years and years now. Even before we co-founded Sherwood together, we have been sitting down and going over what is going on in the world, what that means for economies, and what that means for markets.
This is just something that we do ongoing, but we wanted to invite you into that conversation today. We are going to go through some of the things that we are seeing, and what we are thinking. Every time around this year, we go through different economists that we follow; we follow J. P. Morgan's top economist, we talk about what we are seeing out of our fund managers at PIMCO, several of the different data points that we are looking at throughout the year - to see what they are saying, and then we talk together about what we do with that. Do we agree with that? Do we disagree with that? What are we seeing in the world that matches up with that, and then ultimately, what does that mean for the way that we run our company, for our plans, for our portfolios, and ultimately for our clients.
Today we want to hit on a couple of those themes that we are seeing, what we are thinking about them, and then what that means for us going forward. To kick things off: Matt, we have been talking a lot in the past several months about changes in the fixed-income market, and this is a conversation that you and I started last summer after conversations with fund managers. We had come away from those just looking at these yields, yields that we just have not seen in a long time. I am going to want to flip that to you. What are we seeing in those markets? Why is it important? What is different? What is going on there, to kick off our conversation?
Matthew Davis Sounds great. I appreciate the introduction. And like she said, we are having these conversations throughout the year, all the time, meeting constantly on what is going on in the market. And so, it is fun to take a moment to share what we are talking about with you. It is a great place to start because it has been a big theme, that a lot of people refer to as “bonds are back.” And what do they mean by that? They mean bonds are yielding more - much closer to historical averages, back towards long-term averages, which is remarkable coming off a time where it was a struggle. Depending on the type of bond, you might be getting anywhere from between 1 to 3%. And yield now is easily, even on core bonds, somewhere between 3 to 5%, some of the shorter-term bonds even yielding a little bit more than 5%, and that is a huge difference.
It significantly changes your return options. For us as portfolio managers, that is exciting, especially because we're typically more conservative and less volatile. That portion of your portfolio can return more. That’s been incredibly difficult over the past decade. It took a little pain to get there. We have had probably one of the worst bond sell-offs really in modern economic history over about 18 months, and now the dust has settled, we are seeing bonds offering great value, which is exciting.
One big reason why bonds are more attractive now goes back to the inflation conversation that most people are familiar with, that they felt over the last two years. Inflation really skyrocketed. The Federal Reserve stepped in to bring it back under control--lots of different theories of what caused that inflation--probably some of the easier things to point to is the significant size of the stimulus packages coming out of the pandemic, maybe one too many of those, maybe frankly two too many of those just made the system awash. Then just a mix of supply chain disruptions because of the pandemic: we saw shipping costs skyrocketing, raw materials, things like lumber just skyrocketing, and prices (increased). Lots of different reasons. In the end, the Federal Reserve, as part of their mandate, stepped in and said, hey, we need to bring down inflation. They do that by raising rates, (which are) the rate they lend to banks.
The banks turn around and lend you a mortgage or a business loan that is going to be higher as well, and that typically slows the rate of lending because it is more expensive, which slows economic output, which usually cools the economy, which typically slows down inflation. That has been the big driving force over the last 18 months. So, now we are hopefully near the end of that tightening cycle. The Federal Reserve has come out and said, “Hey, we did it. Not that we are going to stop paying attention, but it looks like inflation has been tamed, it’s quelled in the short term, and you never know what surprises could come up, but at least in the short term, it is all trending down.” It took them a little while to say. Some of us were worried that they might go too long and overly cool the economy and force us into a recession or a deeper recession.
Right now, it looks like the recession risk is low, (but) not nothing. If a recession does occur, the hope is that it would be mild, which is again pretty remarkable for such an aggressive inflationary period, for an aggressive increase of rates that is the fastest the Federal Reserve, pace-wise, has ever increased rates before. And that is where we are sitting now. So, big theme is bonds are back, (and) they are yielding more. It’s because of what the Federal Reserve has been doing. Will it sustain forever? Probably not. At these levels of economic growth, that will sustain higher interest rates like this, even the Federal Reserve themselves is projecting that the rates will be lowered in the coming years.
Will they go back down to that near 0%? I doubt that as well. Probably somewhere in between. Maybe can normalize back in that 3% percent range is what we are predicting, given no major surprises in the market. They’ll probably settle on a neutral rate somewhere in there. I think the FOMC's long-run projection is 2.5% at this point. So that has been a big, big driver of economic news in 2023 going into 2024.
Hannah Boundy I think what is interesting about that too, and you and I have talked about the theme around the work that the Federal Reserve does; it is this balancing act in that there are winners and losers. There have been a lot of discussions about a hard landing (versus a) soft landing. Will there be a recession? Can we avoid it? How are we even defining a recession at this point? And you pair that with things they’re trying to balance; we do not want things to be too expensive, but we do not want them to be too cheap; we want people to be employed. Looking at the surrounding data, we are seeing phenomenally low unemployment in this environment.
As they are making things more expensive in other environments, we would expect to see unemployment start to rise and maybe some of those indicators of recession. And I think that is part of where they are (the Federal Reserve) starting to signal that maybe they will start bringing rates down. And that is great for people who want to borrow, maybe you can get a mortgage for less than those rates that have gone way up in the past year and dried up that market. But at the same time, maybe seeing people who are lending money at high rates come down. And so, for us just wanting to see that big picture—who are all the players, and what does that mean—as they try to execute a softer landing. We will talk a little bit later about what that means for the US. The central bank here has done so well relative to some of the other central banks and relative to other economies. And so, we will talk about that. But I think as we talk about bonds, and bonds are back, it is easy to wonder about the stock market. If bonds are back and the bond market is doing so well, should you just pile into bonds? What do we think of equity markets, what’s going on there?
One question for you, and I think I will just start with something that you and I have been talking a lot about, is just the concentration of the stock market, and is there opportunity in the stock market? There are just some interesting things going on there. I want to throw that to you in terms of addressing what is going on there, what are we thinking, and why does it matter?
Matthew Davis Absolutely. I appreciate that. It has been, and we are constantly having this conversation, and there’s a joke: if we did not do this for a living, [the stock market] would be exciting and interesting because a lot has been occurring that is unusual like we alluded to. We went through this massive rate-hike cycle without unemployment coming up. In fact, it has stayed remarkably low, near historic lows throughout most of the process.
Hannah Boundy And we went through a lot of rough waters with banks. There were, again, winners and losers there, it was not without volatility, and that does happen, right?
Matthew Davis Yes, and yet somehow through that chaos, the aggregate was okay, the average muddled through, and it is fascinating, or I should say, the summation of all the players was okay, but some people did poorly, some people are doing well, and I think especially on the stock market, you are seeing that. So, to your point, bonds represent what we think is a pretty good value nowadays—much higher returns for the level of volatility you take. You know the temptation is, should we massively overweight bonds? Where we get to for our clients as portfolio managers, diversification still has its place. Some stocks are not expensive, not all stocks are expensive, and maybe the summation of the stock market is a little bit expensive, but by no means near historic highs or anything like that. But a lot of the market is not expensive either to what you have alluded to. Since the beginning of 2023, the top 10 stocks have represented nearly 90% of the performance for 2023 of the overall market, which is astonishing. What you are seeing is very few companies are doing well. The Apple's, the Microsoft's, the NVIDIAs, Google, Amazon, I mean, these are companies everyone is very familiar with. And as money has come back in the equity markets for whatever reason, it’s really concentrated there, and, in their defense, a lot of them have done very well with big profits. I was looking at J. P. Morgan, I think they have some record profits for 2023.
Matthew Davis It has been a fascinating theme. What does that mean for us as investors? What should we be doing with them? Continued discipline. That is one of the conversations we have repeatedly. What do we do with this? It kind of drives me nuts, honestly, how concentrated the returns of the market have been. It’s like do you want to outperform the market, then there are five companies you must own, and if you try to diversify away from those at all, you will underperform. So, it makes being disciplined in these times difficult, and this is what we do all the time when we step back, we look at it and ultimately kind of fall back from our principles. We do think that it matters, that earnings matter, and how much you pay for a stock matters in a large portion of the market, that it’s reasonably priced.
You can think, (that) when I own a stock, I own a portion of their earnings, and I am willing to pay a certain amount for that, and I do not want to pay too much. I mean, it makes sense: if I am going to get $100 each year from somebody, maybe I am willing to pay $1,000 for that, right? That would be a 10% return. I feel good about that, especially if I got that year-over-year or if it increases, it is $100 the first year, $110 for the next year, and $150 the next, right? And, you know, I might change my price for that. That is all stock buying is. Sometimes it is easier to get up in all the news, and it sounds fancier than that. But, in the end, that is what is happening. I am buying a company. They owe me their profits.
The issue comes with things that are sexy and fun: Tesla is probably the greatest example of this. For $100 worth of profit (annually), am I willing to spend $10,000? Because maybe I am excited and think the profit is going to increase a lot. I might argue that people got really excited about the new technology, and maybe overly so. That’s where the stock market reflects human behavior. It shows why people would pay so much for that $100 in profit. Whereas if I can turn around and buy, for example, a share in Target for $100 of profit, I might only have to pay $900 or $1,000 - much cheaper than Tesla. This is where a disciplined approach to investing, especially when you have long-term time horizons, still makes sense. We still get excited about that. Admittedly, sometimes it is difficult. In 2022, that was a great strategy that led to massive outperformance, especially in the sell-off, as people were selling companies that were not profitable or weren’t profitable short-term or nearly as profitable. That reversed again a little bit in 2023, but it was very concentrated, it ebbs and flows. But we still stick to a disciplined approach to investing, a diversified approach to investing. These companies kind of rise and fall. It still makes sense to us to make sure we are getting the most bang for our buck.
One of the trickier ones and I’ll switch topics just a bit...when we talk about money markets, money markets have been fascinating, right? It’s really something we do not even consider as an asset class. Typically for us, we have excluded cash. We have excluded money markets from our portfolio for 15 years. Because it’s made virtually nothing. The idea was that if you have a short-term investment need, just keep it in cash. Keep it in your checking account, it is not worth investing. Money market is not worth the hassle, but now we are seeing upwards of 5%. Essentially for cash that will sit there. So, I think it is a great question, one you and I have wrestled with. Now, there’s a really attractive yield. Clients ask us all the time, “should that become a greater portion of our portfolio?” Again, us being long-term investors working typically with retirees—people who really want to maintain their principle over time—does this make sense? I will turn that back to you and ask, why are we not just putting a huge chunk in money market?
Hannah Boundy You and I had this conversation just a few days ago as we looked at returns and yields, and even right now, money markets are sitting around 5%. The US aggregate bond index returned around 5.5% percent last year, and that is riskier. And we have questions around, well, should we just stick stuff in cash? It is twofold in my mind. When are money market yields a short-term investment, and when are they not? None of this is guaranteed, right? We will have a big disclosure at the end. Nothing is guaranteed. The money market is not guaranteed either. Banks are advertising 5%, and that is what it is yielding right now.
But there’s no guarantee that it will yield that in a couple months or next year. The beauty of money markets is that you can get in and out of it quickly. It is liquid versus when you purchase a bond. You’re locking in what that rate is when you buy that bond, because a bond in its simplest form is an IOU. To say that those are equal is not necessarily true because the yield on money market is going to move around. But then the other part of the conversation that we were kind of going back and forth on, is that, if we believe that rates are going to come down and if there’s been a signal. And again, if the last few years have taught us anything, it's to expect the unexpected.
But when we think about economic cycles and when we think about what the Federal Reserve is signaling, the expectation is that rates will come down and, in a vacuum, when rates come down, bond prices go up to account for that. They are balancing that out. I have, one, the ability to lock in maybe a similar yield but for longer with a bond, and, two, there is the potential for that bump. We have these conversations all the time with clients. Well, then, why don't I wait until that bump happens, and then I will switch? But we do not know when that is going to happen. What happened tomorrow could happen in the future. And so, to risk missing out on that price return because we are holding on to too much cash or for too long is a genuine risk, especially for longer-term plans.
We kind of come back to the idea that diversification still matters. We want to hold cash. We want to be mindful of our time horizons, but we do not want to be caught too late. The markets are forward-looking. We talk about that all the time: they move based on the information that they have now, not on when the event occurs. Even if interest rates are going to drop in the spring, the market is factoring that in presently. It is not going to factor it in in the spring, when it happens. It (the market) is going to factor it in as it is warned about it. That’s what we have been tossing around when it comes to cash. It is such a great point. With that in mind, I’d like to turn back to the bigger picture, broader themes. One of the themes that you and I have been talking a lot about is innovation, and a big topic lately has been artificial intelligence.
How do we get in on that? Does that mean tech companies? What does that mean? And it is an interesting push and pull. There are winners and losers. We have got a lot of innovation going on right now. When we look at GDP expectations at the same time, we have demographic headwinds: a shrinking of the population: people are not having as many children. As for broader themes, those are the two things where you expect growth: more people working and people working better. We are getting less people working, but there (also) is this question of efficiency gains. And will those offset jobs, will they gain enough? Who will be the winners? And so, I want throw that back to you. I remember this conversation you had with a client a long time ago when we were early on in our careers and localities were legalizing marijuana, and someone called and said, “which marijuana companies should I buy, because this is going to be great.” You had this conversation with them about the winners and losers, and that we do not know who is going to capitalize on that. We have talked about it too in the context of the airline industry. So, I want to push that back on you to have this conversation about innovation and disruption.
Matthew Davis 100%. I appreciate it. It is a great set-up because, ultimately, what we are investing in—what underpins all investments—is a growing economy. Either that, or we are just stealing from each other's piles, and if someone wins, someone has to lose. The idea being is, no, in a whole, healthy economy, we can all win and the economy itself is increasing, the pie is increasing, and overall both will be doing better over time. To your point though, a big portion of that is there have been more people in the economy, more workers are producing more goods as a large part of growth, the other half being technology, technology advances productivity. With population growth essentially nil at this point, with low immigration and low birth rates, we are completely reliant on technological innovation to grow our economy. The number one factor being AI. It is everywhere, we hear it all the time.
I (have) played with ChatGPT, (and) things like that. The possibilities are really fascinating, but to your point, it is incredibly difficult to predict who is going to do well—back to the marijuana stocks, there have been far more losers than winners. That one was unique because the barrier of entry was relatively low, plus it still being illegal at the federal level, it was difficult. Still mostly losers there across the board. I used to love using the airline industries as an example because that cycle has kind of played out a bit more. Airplanes are an incredible innovation, clearly a huge, huge change for everybody as a mode of transportation. But it’s not necessarily straightforward on how to make money on that. Early airline designers, Boeing etc. dominated for a long time and have done well. Lately in the news, they have been struggling a little bit. It has been a good trade, maybe not a great trade. On the flip side, airline industries themselves and air transportation have done poorly. Tons of the airline industries have gone bankrupt over time and have been a brutal investment. But then maybe on the flip side, maybe some of the things you do not think about (adjacent to) that industry (that) really did well because of airlines (are) things like FedEx, UPS, right, that were able to use that technology. Even though their service is shipping, they have been able to be way more efficient using technology. That is where I get to with AI as well. It is a little bit hard to tell. Is it the AI producers - your Microsofts, your Googles, your IBMs, whoever is running AI and offering it, obviously there will be some benefit to them. They are going to make a bunch selling this, but is it the advantage of selling it, or is it the companies who could do well with it… it is hard to say.
Industries that come to mind that could really benefit from AI—things that you could make it more efficient: R&D, and pharmaceuticals become the easy ones. If they could test out more molecules on a computer instead of going through extensive clinical trials, and if that could be proven to be safe over time, that would have a huge impact on that industry. Good or bad, that’s even hard to tell. If they are all doing that, does it become an arms race? Does it drive the drugs (prices) down?
Hannah Boundy Right, the margins must shrink because of that.
Matthew Davis It is hard to say, and that is where you can both be correct. AI is going to have a big impact on the future, but I do not think there is an easy answer to the question of how you make new money off it. Maybe on an individual level of, “hey, it probably makes sense to specialize in a degree, and AI is going to be a thing going forward.” In some ways, it would be easier to make that bet and invest in being part of it. But from an investment standpoint, it is difficult. You buy Microsoft, you are buying a whole lot more. You buy Google, you are buying a whole lot more than just AI, in contrast to the marijuana stocks, where there are tons and barriers to entry are low. Mostly the large technology companies are the players with the ability to invest in AI, so it is much more difficult right now. And again, I think this is one of those things that makes our job interesting, maybe some nights a little bit sleepless.
What I always think about when we talk about these investment themes, we are trying to do a little bit better for our clients, especially for our firm. We are not looking to crush the markets. Even if we think AI is going to work, we are not going to put in 100% of our clients’ money today. That is not how we work. We like to see these themes, try to understand the impact, and make sure it would pull for our portfolio correctly. And I think one of the things that we do, which is always more important than the individual themes, is to start reviewing the backdrop to the investment world as well.
One of the things that keeps me up at night when I am thinking about these things: the AI is a funny question, right, “hey, how do I invest in this, what is the impact of it, how do I maximize my returns?” I want to make more money that is exciting. That is fun, I think, especially for us because we are conservative, we are trying to protect people's money. It (another question) is what are the risks out there? Unfortunately, in 2024, there are a lot of fires going on out there. As I start thinking through the geopolitical risk just out there and to global investing, maybe turning back to you. How do you see the few hot-button things we’re watching and what we are doing to mitigate that risk a little bit for our clients?
Hannah Boundy I think that is such a valuable question, and agree that it’s something that can keep you up at night. There is a general sense in the economic community of cautious optimism. In the broader community there is just a sense of maybe a little trepidation and exhaustion.
Matthew Davis Absolutely.
Hannah Boundy We have had such a volatile set of years it sets this tone for you. I always laugh in January. Starting the firm, we used to say, “this is going to be a great year,” and we do not say that anymore. We got to, “this year could be okay.” And you look back at the past years and things that we did not see coming: the global pandemic that shook the world, Russia invaded Ukraine. There is this conflict going on in the Middle East right now. You open the news, and there are so many pockets of volatility and uncertainty in markets that are doing well. And then there are concentrations in pockets that have hyperinflation. There’s a lot going on, we have another election coming up.
What do we do with all of that? There’s that underlying theme of “there will be winners and losers.” Different countries are still sorting out what has happened. Last year, there was a surprising resilience to our economy, and then we look abroad and see that the UK is still recovering from Brexit and that was several years ago. Germany is still trying to sort out energy supplies. China, which has been a story for decades now, is starting to see lower growth as it moves towards a more developed economy, and they had COVID lags from pushing back reopening.
Some of that will converge as countries sort out the tensions, political upheaval, and disruptions that were going on there. We may see them get a little bit more growth. But at the same time, we do not know what this year will bring, which brings us to this final point. Diversification is still valuable. Something that you and I come back to a lot in these conversations is saying things like, “What about this and what about this? And where do we bring that together?” We want to be mindful of opportunity and the ways we may tilt towards certain things. Like you said, we are not going to go all in on something because we still believe that spreading across different asset classes, and different economic zones is valuable.
It still brings down our risk. It spreads out our return potential, and we are mindful of what we think we are going to get out of that. At the very end of the day, you and I always come back to planning—what are our plan expectations, and what do our clients need? Are we diversified in a way that gets clients what they need without risking what they have built? I think that continues to be right at the end of the day.
The world has always been volatile. History has always been volatile and unexpected things have come up. So, we lean into this. We do not know what is coming, but we want to be prepared for a lot of different outcomes and not take risks that we do not have to take. I think on that point, we are cautiously optimistic for 2024.
Sherwood itself has a lot going on. We have so many exciting things on the horizon for our clients: new faces, new team members, new services. We have a portal that we are rolling out in a few months and an exciting client event coming this summer. Just all around, I think we are excited. We want to be diligent.
You and I will continue to have these conversations to think about how we can offer the very best to our clients through our investments and broader services. To that end, I want to thank everyone who tuned in for this update. It continues to be our privilege to serve you, to walk alongside you and your families as you build a wonderful financial legacy. We want to thank you for your trust and support, and as always, if you have any questions or need anything, please do not hesitate to reach out to our team. Thank you.
Disclosures: This information should not be construed as investment, tax, or legal advice. All statements and opinions expressed herein are based upon information considered reliable at the time of publication and are subject to change without notice.