Welcome to Season 2, Episode 31 of Meet the Expert® with Elliot Kallen!
In this episode, Elliot Kallen brings on Simeon Hyman from ProShares to discuss how inflation and interest rates currently impact portfolios as well as the future of geopolitical issues in our economy. They share inside knowledge about how investors can hedge against interest rates, take advantage of profitable American companies, and think like a contrarian.
Meet Our Guest
Simeon Hyman
CFA | Head of Investment Strategy | ProShares
“Simeon Hyman, CFA, joined ProShares in 2013 as head of investment strategy. He leads ProShares’ team of investment professionals engaged in portfolio analysis, product research and development, education, and the delivery of investment strategies using the company’s alternative ETFs. Hyman earned bachelor’s and master’s degrees in economics from the University of Connecticut, and an MBA from Columbia Business School. He holds Series 7, 24, 63, and 66 FINRA designations.”
How are geopolitical conflicts affecting stock market volatility and behavioral finance?
Elliot Kallen: Good morning and good afternoon, everyone. I’m Elliot Kallen, CEO of Prosperity Financial Group, and I’d like to welcome you to another episode of Meet The Expert. This is a really interesting program today. I’m very, very excited about what we’re doing.
Here is the CIO for ProShares. ProShares is a specialty company on the East Coast that works with ETFs, exchange-traded, or electronically traded funds. I don’t want to get too much into the weeds of this and we’ll talk more about this. It’s a specialty house with a lot of sharp focus on what they do.
Right now, our world is kind of upside down. We’ve got Russia with Ukraine going on right now. We’ve got inflation. We’ve got interest rates. We’ve got shipping that seems to be messed up. We’ve got China stress going on there with Taiwan. We’ve got containers lined up off of Long Beach, California, two miles long trying to get in here. So, we’ve got a shortage there.
We’ve got problems with finding employees coming out of COVID. Oh my goodness, I can come up with a whole long list of things that are disruptors to the normal economy, and that’s after two years of lockdowns. We’ve got a lot to talk about today. We’re going to talk about the economy and the markets.
What everybody wants to know is, “Am I going to be able to make money?” At the end of the day, our slogan is – If it’s money, it’s personal– and boy, it’s personal. I want to make some money. That’s how people think about their money. Simeon, I’d like to welcome you to our show.
Simeon Hyman: Thanks so much for having me.
Elliot Kallen: Absolutely. Let’s talk a little bit about what’s going on and how we feel about this. I know you deal in a world of money literally every day, and you’re really speaking to clients and prospects about their money, ideas, how to protect themselves, and how to find new opportunities.I’m a big believer that out of every crisis comes opportunity. You know from going back to the Rothschild family 500 years ago when they believed in the French Revolution and they were buyers when the French were revolting.
That’s where the phrase always buy when the streets are turning red came from. Be a contrarian.
There’s a lot on the world going on to be contrarian about right now. Let’s talk a little bit about that. Can we do that? Absolutely. Let’s start with that. We’re in a very nervous time for our clients. I’ve been watching the markets today. They’ve had massive swings on what’s going on with politics, with war, with the drumbeat of war. I mean, two weeks ago, though, when you were in the United States, you couldn’t spell Belarus, much less knew if it was in Europe or on the streets of Taiwan. Nobody knew where that was. Now, suddenly, it’s the border of Ukraine.
Probably half the people in the country didn’t know if Ukraine was in Europe or Russia, or Europe or Asia. The confusion on that there was a difference between Ukraine and Turkey. Suddenly, everybody seems to know what’s going on over there with our 24-hour news in a way that’s never been seen before.
So what kind of impact is this having on volatility and behavioral finance – which means fear and scarcity – that we should be aware of?
Simeon Hyman: First, I would just be remiss to not start with the notion that clearly our thoughts and prayers are with the people of Ukraine. In moments like these, the health and safety of human life out there in the field are of paramount importance.
But, we do have a job to do and I’ll certainly do my best to share some thoughts with regards to what we’ve seen historically, in times of geopolitical unrest. Plus, how that’s tying into things that were happening in the market prior to and will likely happen subsequent to the Russia-Ukraine crisis. Maybe some thoughts on how to position portfolios.
I think one of the key takeaways, as you said, is there are opportunities when situations like this, unfortunately, surface. When you look historically at geopolitical risk, crises like this are more often than not shorter in duration than ones that come from economic cycles.
As an example, the financial crisis, the great financial crisis, or the Great Recession, took months and months and months before the bottom was found, a couple of years before you recover those losses. But, if you look at more acute periods of geopolitical unrest, like 911, you’re talking about drawdown measured in days and weeks in a recovery measured in a few months. So most typically, geopolitical challenges don’t last too long and don’t have a real long-lasting implication for portfolio performance.
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How does inflation impact portfolios, especially for our most conservative clients?
Elliot Kallen: Okay, so that’s good news for investors who are a little bit scared. I had one investor that said to make sure that we convert everything to gold before the day is up. And I just sat here and I said, “What are we going to do with the gold? Where does that go? Is it safe?” We have cash registers shut down because of a cyber attack. What do they do with the gold and buy anything anyway?
So let me talk about something that was happening, maybe it’s kind of irrelevant now. Or less relevant is maybe a better way of saying that. Its interest rates, inflation, fear, and the Federal Reserve. There was a lot happening right before the invasion of Ukraine, and it was fear that we have runaway inflation of 10% which means I have less buying power as a consumer.
We fear that the Federal Reserve is going to raise interest rates. So we don’t have what happened in the 1970s. If that does happen, that clamps down on the world of bonds and makes them less attractive in that world of fixed income. This means that clients that are looking for safety, security, and conservativeness in their investing, are almost guaranteed to go down. We don’t want that to happen.
What’s going on with inflation?
How do we what is going to happen with the impact of that on portfolios for our most conservative clients?
How can we, as portfolio managers, hedge this so the client based on this negative event of inflation can be the winner?
Because they hedged it properly or we did it for them.
Simeon Hyman: Great questions. The core of the answer here is that most of those things that we were worried about, namely, a little bit of inflation and rising interest rates, those concerns should not really dissipate or be dismissed because of the Russia-Ukraine conflict.
If anything, the inflationary pressures are probably a little bit enhanced for a while because of the pressure on oil prices and commodities. Some of these pressures, by the way, were mitigating. You mentioned, Elliot, at the top of our discussion, all the ships that were lined outside of Long Beach. I’m an East Coaster, and there was some outside of Newark. Some of that pressure started to mitigate at least prior to the conflict.
So, the Baltic Dry Index is the measure of the cost of those dry bulk containers in those ships. It actually fell about 75% from its peak last October. So there were some promising signs that 7%, 8% inflation was probably going to come down to maybe not the Fed targets but something like 3-4%. That still seems more or less in the cards. It also seems in the cards that the Fed will hike interest rates, even in the face of geopolitical concerns. Now maybe if you thought there were going to be rate hikes maybe they’ll only be four or five, but they’re likely to be some.
More importantly, we’re also likely to see – we’ve already seen this – the end of what was called “quantitative easing,” or the end of the Fed buying bonds to artificially suppress interest rates.
So, what do you do with your bond portfolio in the face of rising rates? Now, by the way, the only real reason you would want rate exposures if rates are going to fall? Because when interest rates come down, bond prices go up. And I’ve always said, hey, the only time that might really work in an environment like today is if there’s some big geopolitical conflict. Okay, we just had it, but think about how much pressure there must be on interest rates to rise. They’ve only come down a smidge since the Russian invasion.
It’s very likely that as this dissipates, rates are gonna go up. What does that mean? Bond prices go down? It means you’re safe. Fixed income investments are not so safe. What’s the answer? You hinted at it. We think one of the best approaches is to actually formally hedge the interest rate risk in your bond portfolio.
Now, you only do this with corporate bonds. If you did it with Treasury bonds, you would just be recreating cash because the only risk in a treasury bond is interest rate risk. But a corporate bond has this spread. You have to earn more interest on a corporate bond because it has a risk of default. If you buy those corporate bonds and you hedge the interest rate risk, you got a great opportunity to make some money even as interest rates rise.
Plus, by the way, back to your point about an opportunity in times of stress, that spread on those corporate bonds is actually widened.
Much like equities have lost a little money during this geopolitical crisis, which means you have an entry point that has even a little bit more upside to the strategy. So that’s certainly one possibly important element of a fixed income portfolio in a rising rate environment is to actually hedge the interest rate risk in a corporate bond portfolio. We do that in our ETF ticker, IGHG.
Can you explain what “hedge” means?
Elliot Kallen: What does hedge mean for our clients? Can you explain that?
Simeon Hyman: It means that you’re actually protecting your investment from the impact of those rising rates. So think about owning a corporate bond. If you own a corporate bond, there are two risks. One is the underlying Treasury rate risk and the other is the spread on top of it. Imagine today the 10-year bond is 2%, and a corporate bond is at 3%. There are pretty high odds that the 10-year interest rate is gonna go maybe to two and a half percent. The corporate bonds might only go up to three and two, three and a quarter because those spreads are compressing.
We want to protect that portfolio from just the increase in the treasury rate. So in effect, what we’re going to do is staple a short position in treasuries to that corporate bond portfolio, isolating the good credit part, particularly attractive after the Russian invasion of Ukraine. We isolate that in the portfolio. Therefore, the hedge takes a specific position contrary to the impact of those rising rates on the treasuries stapled to the corporate bond portfolio.
“Much like equities have lost a little money during this geopolitical crisis, which means you have an entry point that has even a little bit more upside to the strategy. So that’s certainly one possibly important element of a fixed income portfolio in a rising rate environment is to actually hedge the interest rate risk in a corporate bond portfolio.”
What does the consumer need to be aware of when hedging interest rates?
Elliot Kallen: Okay, confusing for clients and that’s why we build portfolios and have conversations here. We’re talking about inflation, so let me just stay with inflation for just a moment. My concern is that we’re dancing with China. We’re dancing with China where their goal is perhaps some type of world domination. I don’t know if they’re gonna go into Taiwan or not, but it’s to control purchases throughout the world. They want to dominate the economic world, they’re already dominating a good part of it, which means prices are going up there as well.
That’s where inflation is coming from as well. So when you’re talking about hedging interest rates, and I know that’s just the beginning of that word hedging, What does the consumer need to be aware of? To say, “I want to take more risk or less risk as an investor with you, Elliot.” What should we be looking at or having a conversation about
Simeon Hyman: The good news is that inflation is usually driven by an improving economy. Now, there’s only one state of the world where that doesn’t happen. And it’s usually when there’s some sort of external shock. That happened in the 1970s with the oil crisis. I think if you talk to most observers of the current geopolitical setup, that’s not the expectation.
In other words, we are likely to resume whether it’s in a couple of weeks or a couple of months, a path of economic expansion that’s driving that inflation, and when that’s the scenario, it’s actually okay to take some risks. In fact, historically, equities have done just fine in that scenario while bonds are defenseless. A bond pays a fixed coupon. So when those interest rates rise, bonds have to lose money unless you hedge and protect yourself.
Equities grow. That’s why equity is so important, their cash flows, their earnings, and really importantly, for a select number of stocks, dividends grow. There’s no better bulwark against inflation than the growth of those dividends in your portfolio. Adding to cash flow over time, so you really can’t do the turtle thing in the face of some of this inflation.
You have to take a little bit of risk, but we certainly think one prudent path for that is companies that consistently grow their dividends because you can’t fake them. You can’t manufacture dividends unless you’re really generating those earnings and cash flows and managing your balance sheet very effectively.
How can clients benefit from American companies that have great cash flow?
Elliot Kallen: So that brings us into where are we investing in. So I’m a big fan. I know there’s a global world out there. There are places to invest outside the US and we take advantage of them, but we invest nothing in China. We haven’t been investing in China for four-plus years now. We do have some in Europe. Obviously, it’s getting pounded right now. But we feel that’ll come back but for the most part.
I’ve been a big fan of what’s called King Dollar, the old Larry Kudlow King Dollar concept. America’s got good companies and manufacturers in smart situations. We know what we’re doing. I know that growth right now has been pounded.
The technology sector has the power there but it’s not going to be there pounded forever. It’ll swing back because America has good companies. America has great companies that have great cash flow and are world leaders. So I know you’re a big fan of investing in these companies. Tell me how this works and how clients can benefit from American companies primarily that have great cash flow and how are they the beneficiary of that?
Simeon Hyman: When you look at companies that have been able to consistently grow their dividends year after year after year, as you mentioned, this is the clearest evidence that they are growing their cash flow over time because you can’t fake it. But there is also another important benefit of companies that consistently grow their dividends. That is what they’re telling you. If a company buys back some stock, that means the good times were yesterday so if they have some extra cash around they’ll buy back some stock.
But when a company increases its dividend nobody ever wants to cut a dividend. So that is a really powerful forward-looking signal of the ability to grow those cash flows and those dividends over time. That’s a really powerful combination. It’s an evergreen, powerful combination. It’s particularly effective in the US and is particularly important in an inflationary environment.
To give you an example, the S&P 500 dividend aristocrats. These are companies that grow their dividends for 25 straight years. Our ETF Halsey Index and its’ ticker NOBL, those companies last year grew their dividends double digits, and even in 2020 at the depth of the pandemic grew their dividends double digits. That’s in a period of time when the S&P 500 barely squeaked out any growth dividends. So, yes, you’re US-centric in this environment. Not a bad idea. But focusing on those dividend growers can really be belt and suspenders in this kind of environment.
Elliot Kallen: I mentioned COVID and what’s going on with that. Obviously, we’re coming out of COVID unless by the time we speak and this airs we have another odd breakthrough of COVID. But we’re coming out the world basically shut down. We shut down. You shut down. You’re working still out of your house.
Simeon Hyman: I thought it wasn’t so obvious I was in my house. I have this clever background behind me.
“”Equities grow. That’s why equity is so important, their cash flows, their earnings, and really importantly, for a select number of stocks, dividends grow. There’s no better bulwark against inflation than the growth of those dividends in your portfolio.
How can investors take advantage of investing in online retail?
Elliot Kallen: I can’t tell if that’s a curtain, a shower curtain, or better – it’s all good. But it’s changed the way people are shopping. It changed the way people are looking at this and I have to say, I’ve been a big fan of supporting local stores and local restaurants through this whole thing. But I’m now having things delivered to me much more than I ever thought I would.
I buy more on Amazon and I’m buying on costco.com. I went to a vitamin store the other day, my favorite vitamin store where I get a nice discount that they extended to members. The shelves were 20% bare. I thought I just got to buy more stuff online and I did because they just don’t have it anymore. So the world is changing in retail.
You know, two generations ago we were talking about Sears and Roebuck and JC Penney, and how they’re doing so well. Some of these brick-and-mortar stores, like to go to Macy’s you got to go to the mall. Who’s bookending and who’s anchoring the mall? We’re gonna have a conversation about that right now. Malls might be closing and becoming townhouses. So retail shopping is changing.
How do the clients, rather than be scared of where they invest heavily, take advantage of this? Besides just buying Amazon stock at $2,000. What do they do? How do they take advantage of this?
Simeon Hyman: From our perspective, there really is an opportunity to invest in online retail. At ProShares we realized a number of years ago that the investable retail opportunities were kind of muddled. In other words, you had to invest in the sector which was a mix of online and old brick-and-mortar stores. We simply split them up and we have an ETF ticker ONLM that invests in online retailers.
Now there’s an evergreen part of this story, and then there’s a particularly interesting current entry point that is all described first. Many people would be surprised to hear that despite all the packages piling up in front of your front door today, just under 13% of US retail is actually conducted online. I think if we took a poll of people they would say 40, 50, 60, 70, 80%. So we’re much earlier in this transition than I think people anticipate the trajectory has been the growth of maybe about a percent and a half a year. So that would mean just four or five years from now that the online retail opportunity would be 50% bigger.
That’s a big growth opportunity. But there’s also an entry point. It’s interesting. Now, why is that? Number one, there has been what I would suggest is an excessive rebound of the brick and mortar stores led up to your point as we began to emerge from the pandemic and stores reopen. There’s been a rally in brick-and-mortar stocks which probably has gone a little too far. In fact, the valuation of brick-and-mortar retailers compared to online retailers is now double what it was before the pandemic. Doesn’t seem to make any sense, especially when the margins of the online retailers continue to grow at the expense of the brick-and-mortar folks.
The other item is China, as you mentioned. There’s a big regulatory overhang in China. Oh, and OLNM’s portfolio was global. About 20 20% of it was China and it got decimated. Where are we at today, this attractive long-term secular growth opportunity for online retailers? They’re trading at half the valuation of the consumer discretionary sector. And the Chinese piece is trading at 25 cents on the dollar. So an opportunity to engage in the long-term trend, but at a particularly opportune moment.
Can you explain the division between stock market prices and actual company profits?
Elliot Kallen: Well that’s a good point. Let me talk about risk for a second because you talked about some things cut in half or down by 25% and so forth. I know that you’ve been heavily invested in online pet stores. And COVID, boy, we proved that we love our pets. Everybody that buys something online is using credit cards or Venmo or PayPal or MasterCard, and these are companies that have just been beaten on in 2021.
Some of these have by 40 or 50%, which could make no sense because we’re not buying less online –we’re buying more. How do financial technology firms like PayPal, Venmo, and Mastercard go down so much? Or pet stores like Petsmart go down so much when profits are just going up on all of them.
How do you have such a division dichotomy? Lack of understanding and how do you explain that to clients? How can I come around and say I want to be in front of the trend and the trend is going down but the real dollars are going up? There’s a real division in logic and investing there.
Simeon Hyman: Listen, you will get disconnects from time to time. It was the old Buffett wisdom that said, “The market is a popularity machine in the short run and a weighing machine in the long run.” So sometimes you do have to look through. Indeed, I think a lot of this was over the past six to 12 months, simply a rebound in some of the traditional brick-and-mortar players that just went too far. Really, if you think about it, these were companies that were trading at 40% of the price to book of online retailers in 2018 and now they’re up to 80%.
That’s exactly in a period when the margins of those online retailers increased dramatically but went nowhere for brick-and-mortar folks, and sometimes disruptive technologies. Sometimes the incumbents win, but usually, they don’t.
And there’s still so much pain, so much store closing that has to be done. We are years and years away from the footprint of a Walmart turning to half a robot-driven drone thing for last-mile delivery. When we get there this won’t matter anymore, but it matters for the league a long, long time from here.
“The market is a popularity machine in the short run and a weighing machine in the long run.”
What advice can you give investors on how to be a contrarian?
Elliot Kallen: Let me wrap this up if I could because you’ve been great about your answers. And that is contrarian, think like a contrarian because I know you’re trying to do the same thing there.
The big investment houses do the same thing. But most investors run with the flock. They don’t think contrarian. They think if somebody’s selling then I must be selling too. If somebody’s buying anything you’re buying, so they’re buying too high. They’re selling on the downside. They’re doing the opposite.
What advice do you have for our clients to be a long ball player, to think out of the box when the market goes down? Think if everything’s on sale, I need to be a buyer. Everything’s been going up and I need to take some profits. It runs so counter in the investment world. If I was a retail buyer at a mall and I found out they were having a 40% sale, and I needed the Scotch or suits or cosmetics or whatever, I’d be running over there right now. But in our world, they’re selling instead of buying. What advice can you give us?
Simeon Hyman: Well look, the first thing you might want to do is sit on your hands to make sure you don’t do anything stupid. That’s the first principle. The second thing is to pick up the phone and call you guys and discuss it because it is hard. It is behavioral finance. It’s so much the recency effect is big and risk aversion is big. These are real things that cause momentum in the short term. So, folks are not alone.
That’s why momentum can drive markets for weeks and even months. But if you have a reasonably long time horizon, and I’ll remind people what a long time horizon is. It’s not just retirement because I’m hoping not to die at 66. My mother is 98. So when I hit retirement, I think I’m hoping for another 30-plus years to go. So, most of us have pretty long time horizons. And you know, the good thing to do is nothing and an even better thing is to take advantage of some of these opportunities.
Elliot Kallen: Really appreciate your help here for our clients. We’re with the CIO of ProShares, and if you want to know about some of the symbols that he talked about, plus we talked a little bit about risk and understanding the risks associated with investing, give us a call. We can show you how we use the ProShare products as part of our portfolios, so you can understand what we’re doing and the logic behind it between our many portfolios. We look forward to seeing everybody on the next episode.
