Guest: Charlie Smith
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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- Guest Introduction: Charlie Smith
- Predictions for the Rest of 2015
- The Multiple of 17
- Value or Growth?
- News, Politics, and The Market
- Pension Liabilities
1. Guest Introduction: Charlie Smith
Dan Weinberg: And welcome to The Lange Money Hour. I’m Dan Weinberg, along with CPA and attorney Jim Lange, and tonight, we welcome back to the program Charlie Smith, Executive Vice President and Chief Investment Officer of Fort Pitt Capital Group. Over the course of his thirty-two year career, Charlie has held leadership positions at several Pittsburgh regional investment firms. He’s also been a frequent lecturer and commentator on the economy and the markets. You might have seen him on CNBC or read his work in the Wall Street Journal. Tonight, Charlie is going to give us his financial forecast for the remainder of the year. That includes the key policy and political drivers for potential change for better or for worse as we head towards 2016, and you’ll learn why Charlie refers to the financial recovery over the last six years as ‘half-baked.’ As always, we’d love to take your calls and answer your specific questions tonight as we delve into these issues. So, to join in the conversation, please give us a call at (412) 333-9385, and with that, let’s say good evening to Jim Lange and welcome to Charlie Smith.
Jim Lange: Welcome, Charlie.
Charlie Smith: Before we get into the substance of tonight’s program, I do feel honor bound, and maybe even legally bound, to say that I am not independent with regards to Charlie Smith and Fort Pitt Capital Group. Usually, when I have guests, they are typically leading experts who have written a book, and if they wrote a good book, I will usually put in a little plug for the book. But I don’t make any money on the sale of the book, nor do I make any money if you utilize any of their services. That is not true with Fort Pitt Capital Group and Charlie Smith. Fort Pitt Capital Group and I have an arrangement whereby if you come to our office and we think that you are a good candidate for money management, and particularly active money management, Fort Pitt Capital Group and I have an arrangement whereby our office does, what I would call, certain strategic work, such as Roth IRA conversion analysis, Social Security analysis, safe withdrawal rate analysis, some tax planning, some estate planning, and that is one component that we do. We also do, what we call, run the numbers, which is we do long-term projections given a variety of scenarios. For example, different Roth IRA conversion strategies, different Social Security strategies, different spending strategies, etc. Then, we refer to mainly two money management firms: one is Fort Pitt Capital Group (which is why I’m not independent), the other is to a group that does index investing, which is DiNuzzo Index Advisors. But if you like active money management (and historically, we have more clients with Fort Pitt Capital Group than with our index advisors), then we would refer you to Fort Pitt Capital Group, and we have an arrangement whereby there is a split of the fee. So, we think it is a win-win-win because our company gets to do what we like, which is to run numbers and to be the, let’s call it, strategic or Roth, Social Security side and handle other things like that. Charlie and his group actually manage the money. And then, the fee for that is one percent or lower, depending on how much money is invested, and then there is a split between Fort Pitt Capital Group and us. So, I do feel honor bound to say that I am not financially independent of Charlie Smith and Fort Pitt Capital Group and wanted to disclose that right up front.
So, with that, welcome Charlie!
Charlie Smith: Well, thank you, Jim. I appreciate being back. I always have fun. It’s great to see you again.
Jim Lange: All right. So, every year, Fort Pitt Capital Group has a client appreciation event, and it’s always very nice. It’s at the Carnegie Library, or the area right near there, I guess it’s Carnegie Hall. And Charlie makes a prediction on what will happen for the upcoming year. And the other thing that he does is he tells us what his prediction was for the previous year, and then he tells us how he actually did. In other words, was his prediction accurate? And it’s pretty remarkable. He’s usually very accurate. So, with that build up Charlie, what do you see for the rest of 2015?
Charlie Smith: Well, thanks for that, Jim. We believe in accountability at Fort Pitt Capital, and that’s part of the accountability process. But this year, at our event in January, we came out with our basic parameters for what we thought fair value was for the S&P 500, where we thought the economy would go in terms of growth, and where interest rates would go, as well. As far as the economy’s concerned, U.S. economy, we were thinking that we would see growth, GDP growth, real GDP growth, somewhere north of three percent this year. Really, for the first time in this recovery, in this initial…we’re into our sixth year of the recovery since the recovery began in July of ’09. So now, we’re six years in and we haven’t had a three percent year, three percent real growth on an annual basis. We were predicting here in the first part of the year that we would finally break that streak and that we would get to a three percent growth rate. First quarter numbers were not particularly promising in that regard. As we saw last week, first quarter GDP growth on an annual rate came in, I think, .3%. So, just like we did in 2014, we’ve seen the initial quarter of the year be a bad one. Last year, second and third quarter, we saw real nice growth rates in the three, three-and-a-half, four percent range for the second and third quarter, and we actually got close to a three percent number for the year. So, we’re going to have to see an acceleration to get to our three percent growth number. We think it’s going to happen.
Jim Lange: Well, three percent growth is one thing, but what about our investors? How will they likely fare?
Charlie Smith: Well, as far as parameters, how that growth translates into profits and the value of the S&P 500, we think that we’ll see earnings from the S&P of around $121 per S&P 500 share. So, if you put a seventeen multiple on that $121 number, it gets you into the $2,050-$2,090 range for a fair value for the S&P, and the S&P closed today at $2,081, I think it was. So, our sort of single point prediction for year-end 2015 for the S&P 500 was $2,091. And as I said, we’re at $2,081 today. So, we’re four-and-a-half months into the year, and we’ve already surpassed our goal for the entire year. So, that’s sort of our way of saying that we don’t have great expectations for the rest of the year for returns from the average U.S. stock, particularly large cap U.S. stocks.
Jim Lange: All right, and you mention the multiple of seventeen.
Charlie Smith: Yes.
Jim Lange: Is that a magic number? Why did you say that…?
Charlie Smith: Well, right. Great question.
Jim Lange: And is that fair?
Charlie Smith: PE multiples (PE being the price-to-earnings ratio) correlate inversely with inflation rates. So, if you have low inflation, you’re going to have a higher multiple on a dollar of earnings for the average stock. If you have high inflation, conversely, you’ll have a lower PE multiple. Historically, when inflation has been running in the one to two percent range, we’ve had PE multiples in the seventeen to nineteen range. So, yes, to answer your question, we are right around what we believe to be fair value for the S&P 500 to the average U.S. large cap stock.
JJim Lange: All right. Well, speaking of value, and maybe this isn’t a fair characteristic, because I know that you have well-diversified portfolios with representation in all the major asset classes, but I think of you as a little bit more skewed towards value rather than growth, and is it fair that, let’s say, your average portfolio might have a lower price earnings ratio?
Charlie Smith: Absolutely, absolutely. The businesses that we own, we own at prices which would definitely put them into the value category. Weighted average price earnings ratio in the portfolios that we manage comes in typically twenty percent, at least, below the S&P 500. So, typically, it’s twenty to twenty-five percent less. So, weighted average PE in our portfolios is in the thirteen range. So, that does reflect the value bent to the portfolio.
Jim Lange: Well, it’s interesting. I remember discussing with you my own personal portfolio, and I was a little bit worried that we were over weighted in stocks, and what you were trying to tell me was it is not just about stocks and bonds. Look at the stocks that we own. And that because they were more value-oriented that they were not as likely to lose money in a downturn.
Charlie Smith: Absolutely. The prices are less likely to decline. In an environment where people are enamored of stocks with high earnings momentum, willing to pay higher multiples, people tend to ignore the need for downside protection. But we’re now into our sixth year for a bull market, and people are tending to forget that there is another side to the cycle at this point, and that’s when the companies that have the lower PE ratios are going to do better. We characterize our return profile over time as we make less when the market’s roaring ahead, but we keep more when things are bad, and that’s always been our MO.
Jim Lange: Okay. So, it’s basically, let’s say, a safety first or preservation of principle first.
Charlie Smith: Umm-hmm, always.
Jim Lange: All right. So, just in those examples, something like Amazon, that would have a very high price earnings ratio, would not be your favorite stock?
Charlie Smith: No. Companies in the biotech realm, in general, don’t even really have earnings, social media stocks, companies that Wall Street is thinking have an opportunity to make money down the road, but really maybe haven’t made a dime yet, oftentimes sell at infinite price earnings multiples. If you have no earnings, or very little earnings, your multiple can easily be a hundred, two hundred, three hundred. Those are companies we would stay away from. We want to make sure a company that we own not only has an operating record that we can discern pretty readily, but also is selling at a price that makes it a good investment for us today. We think that’s the biggest mistake that retail investors make is overpaying for a business, and really, there are lots of companies out there that are great companies, but because of the price at which their shares sell, they’re bad investments. So, you need to differentiate the two, and many people will just think, “Oh, it’s a great company. It doesn’t matter what price I pay.” Certainly not true. Then there are companies out there today that are selling at fifty, sixty and seventy times earnings that are good businesses, some of them may be great businesses, but they’re bad investments because they sell at prices which, literally, the math just doesn’t work to make them good investments.
Jim Lange: And I don’t know if it’s fair, but I do think of you as a little bit of a bargain hunter, if you will.
Charlie Smith: Absolutely! Yeah, I’m an old Scotsman, so I find my way to the companies that sometimes are a little downtrodden. For whatever reason, a business will be going through a rough patch, and they’ve got a track record which we can understand, number one, and two, maybe the investing public is a little bit sour on. You know, those are the opportunities that we’re looking for.
Jim Lange: On the other hand, you don’t seem to be a big time trader, and that is, there’s a relatively low turnover, and I remember one of the questions at one of the events was, “You mean, you don’t make that many trades and you charge one percent (or maybe a little less, depending on how much money is invested) just to ‘watch over’ what you’ve already decided?”
Charlie Smith: Right, right. Yeah, we get that occasionally! There are some people, some investors, that believe that trading activity equates with management, and really, nothing could be further from the truth. You know, we’re like the proverbial duck: there may not be a whole lot on the surface in terms of trading activity in the portfolio, but we are every single day trolling the waters for new investments, keeping track of what our companies are doing with regard to their investment, their plans for future investment, their earnings, their capitalization. We’re keeping track of every single one of the companies that we own and looking for new ones, but frankly, the excessive trading activity can drive down your returns just as easily as paying too high a fee.
Jim Lange: Okay. Well, I had another question. I’m getting this more and more lately. I have clients that are coming in and there’s some fear, and sometimes they have a cash event, or maybe they had stock options, or for whatever reason, they’re sitting on cash and they’re saying, “Geez, you know? I really am a market investor. I have been in the market. I have made money in the market for my whole career. But right now, things are just too crazy. Things are too volatile. I’m just afraid, and I’m going to kind of sit on the sidelines. And then, I’m going to wait and then get into the market.” I’m hearing that a lot, and maybe you are too. Maybe you not so much because you’re actually probably spending more time with actual clients, who you have managed to train away from that attitude.
Charlie Smith: Exactly!
Jim Lange: But how would you respond to somebody who…you know, they’re intelligent people. They just maybe don’t like what’s going on politically now or for whatever reason, they just think that we’re on the verge of a collapse.
Charlie Smith: Right. Well, there are always going to be reasons to be fearful. Sometimes, there are more than others. Sometimes, there are legitimate reasons to be fearful. The folks that were coming to us in the latter part of ’08 and the early part of 2009 with concerns about the viability of the U.S. economy for the long run, legitimate fears. There are other fears that are driven by media hype. Part of it involves separating what is driving the fear from typical emotional human behavior and deciding whether those fears are legitimate or not and whether those fears are priced into the stock market.
So, we try to take a step back and say okay, what is your time horizon for the money that you have invested? And if the person that’s come to us with the fears that you’re talking about is eighty years old and they only have enough money to last them the rest of their lifetime on a fairly high withdrawal rate from their portfolio, we would probably commiserate with those folks and say, “Well, look. You need to have a significant portion of your portfolio in liquid assets, and your fears are legitimate.” By the same token, someone who comes to us who’s fifty-three years old and says, “Yeah, I’m going to need this money fifteen years from now when I plan to retire. I’m just thinking that it’s just scary time and I need to be out of the market.” We’re going to have a completely different attitude towards that person. We’re going to say, “Look, even after you retire in thirteen or fifteen years, you’re probably going to live another twenty years beyond that. So, your investments have a time horizon of probably twenty-eight, thirty years at this point. You can’t afford to be out of the market.” So, the tactical changes that a client like this is suggesting are, given the entire financial history of the U.S., counterproductive. So, that’s the sort of perspective that we try to provide.
Jim Lange: You said something else that was interesting to me. You said it might be something that is ‘already priced in the market’.
Charlie Smith: Umm-hmm.
Jim Lange: So, let’s say, for discussion’s sake, you know, we read headlines about all the terrible problems that Europe has. So, somebody might say, “Oh, Charlie, you know, Europe has all these problems. You’d better sell every investment that you have that has anything to do with Europe.” Or they might read something good about the developing countries in Asia or wherever. Can you talk a little bit about, let’s say, news and what is, in effect, already priced in the market?
Charlie Smith: Sure. There’s an old saying in our business: if it’s in the press, it’s in the price. The markets are a great discounting mechanism. They take the sum total of all information available about the economy and companies, and the market’s job every single minute that it’s open every day is to take that information and distill it into stock prices, and that’s an ongoing function pretty much almost twenty-four hours around the world, considering that stock markets are pretty much open continuously around the world. So, the markets are busy pricing in every new piece of information almost as soon as it’s available. The efficient market theory says that you really are not going to be able to outperform the stock market because you have a piece of information that somebody else doesn’t have. Basically, the thesis is that the markets are efficient. We would counter that because human emotion is involved in the equation, it will take this discounting mechanism to extremes, and when you overlay fear and greed on this discounting machine, it gives you opportunity to take advantage and take the other side of that. But to get back to the key point, the market is a discounting mechanism, and if you’re reading about it, there’s a pretty good chance that the folks who manage serious money, you know, the folks that are running multi-billion and trillion dollar portfolios, they were probably thinking about this months and months ago, and probably positioning their portfolio to take advantage of it at least weeks and weeks ago. So, if it’s in the press, more than likely, if you’re worried about something that you’re seeing in the press, it’s already priced into the market. It’s important to know how the market responds to news. You can always learn a lot more, in my opinion, not from what the news is, but how the market responds to it as to whether that new information is already priced into the market.
Jim Lange: Well, Charlie, I know, usually, most of your advice is classic and that some of it could be replayed ten years ago or ten years from now and it would still apply. On the other hand, we are in the early part of the political season for the national elections, and I would want to know if you take into account what is going on politically, both in general and specifically now, into what you think will happen with the economy and if that has any impact on the decisions that you make as a money manager?
Charlie Smith: Jim, the folks that write the rules in Harrisburg and Washington will impact the financial realm. It happens with a lag…you know, rule changes tend to happen glacially, significant rule changes like a big tax act. I remember back during the latter part of Ronald Reagan’s tenure, in his second term, we had the big tax law change in ’86 that basically swept aside a lot of the old depreciation rules with regards to a lot of the tax shelters out there.
Jim Lange: Yeah.
Charlie Smith: But really, I think we’ve created a tremendous boon for the economy. But the point is that the people that write the rules can definitely change the game. So, you need to pay attention to it. As far as the current election cycle, we’re not necessarily paying a whole lot of attention to what’s happening now. The game will really begin once we get the primaries over with and we start to see, along about the summer of next year, we start to really get an idea of who the candidates are, and then we can sort of see…we handicap who’s going to win: Republican or Democrat. And even then, it’ll be certain specific areas of the marketplace that are going to be potentially affected by a change of administration. If we do get a Republican who happens to be a little bit more of a hawk on defense, it wouldn’t surprise me, if that person starts to gain in the polls in the summer, that the defense group of stocks would begin to perform well. Just one example of a change. A longer-term change that’s going to be discounted early, even though that change doesn’t sort of come into clear focus until Election Day. So, yeah, we’re going to be paying attention to the key issues.
One of the key issues in this cycle is just how realistic are the chances that Obamacare would be repealed. Right now, the odds on that are probably less than one or two in ten, but if a Republican candidate runs on a platform of repeal and is able to get significant political traction, the entirety of the improvement in the financial health of the insurance group that has been such a big beneficiary of the law change, that could come into question. Some of the huge revenue increases we’ve seen for the pharmaceutical groups could be sort of turned upside down if we do get repeal. So, the sort of big tectonic changes that happened as a result of a philosophical or political wave absolutely need to be factored into the equation, but we really won’t be looking to do a whole lot of that until the summer of next year.
Jim Lange: Well, I know this isn’t anything that you do, but I actually know at least one financial planner, and he is, I think, one among many who loves to scare the bejeevers out of their clients and prospects, and he pulls up a website that shows what the national debt is, and I believe right now it’s a little bit over $18 trillion. And then, to make it worse, it’s scrolling. So, it’s literally gaining hundreds of thousands of dollars every second that you watch it. And he says, “Oh, this is really bad!” And then, of course, he tries to sell you an annuity.
Charlie Smith: Sure.
Jim Lange: How would you respond to somebody who says, “Hey, with the debt that we have, how can our economy possibly do well?”
Charlie Smith: Well, first of all, there is enough static out there that I don’t need to be adding to it by throwing sort of a straw man up in front of my customers, my clients, and telling them, “You need to be afraid about this.” There are plenty of other people out there doing that every minute of every day, so the less I do of that, the better. But as far as the issue of the debt, the debt comes from the deficit. The annual deficit has been shrinking as a percentage of U.S. GDP significantly over the past six years. The deficit this year came in under $500 billion versus a deficit north of $1.1 trillion five or six years ago. So, we’ve shrunk the deficit by more than fifty percent.
Jim Lange: Which basically means the rate of debt that we are…
Charlie Smith: Per year.
Jim Lange: …per year…
Charlie Smith: Exactly.
Jim Lange: …is shrinking, but the debt itself is still going up.
Charlie Smith: Right, the debt itself is still rising.
Jim Lange: Okay.
Charlie Smith: But the rate of increase has shrunk by more than fifty percent over the past five or six years, mostly due to the tax laws enacted in 2012, or 2011 I guess, that included the sequester, which was an automated way of reducing federal spending, and that sequester is still in place, by the way. In fact, the Republican Senate just passed a budget yesterday which maintained significant components of the spending sequester, which we applaud, and it now looks like a group of House and Senate negotiators are going to get together and remove some of the spending limits that were part of the sequester and have driven the budget deficit down. So, it looks like we’ve bottomed out in terms of the deficit. So, the deficit looks like it’s going to begin to rise again. So, the debt, which the last couple years as the deficit’s been shrinking, the debt hasn’t been as big a topic or popular a topic, but it’s going to become one again because once again, the deficit is starting to rise again. So, the debt from our perspective becomes an issue when it grows at a rate greater than GDP growth. And so, if you get debt growing at three percent and the economy’s only growing at two, and that happens for an extended period of time, the curves diverge and your economy gets in trouble. If your debt is growing at a rate less than the growth rate of GDP, the economy can comprehend that quite well.
An added factor that’s benefiting our ability to take on debt is the fact that the Fed has driven interest rates so low. If the Fed is really sincere about driving rates back up, normalizing interest rates, so to speak, and we go from a three percent thirty-year treasury bond back up to a normal rate somewhere in the five, five-and-a-half, six percent range versus historic, all of a sudden, that $18 trillion of debt that we have on the books becomes a little more problematic. It’s becoming more expensive as interest rates rise. So, that’s another ingredient in the equation that we need to be concerned about. But right now, if we continue with a $500 billion deficit, and the economy can manage to grow at three-and-a-half, four percent annually, which we haven’t quite been able to get there in this recovery, but we’re approaching it, that’s something the economy can handle. So, we’re not particularly concerned about the debt, unless the debt itself begins to approach that trillion dollar level.
Jim Lange: All right, and is that related to quantitative easing?
Charlie Smith: Yes.
Jim Lange: All right, so is that something that scares you, or that you’re happy about, or a little bit of both?
Charlie Smith: Well, I think in some ways we were happy about QE1. Let’s describe what quantitative easing is.
Jim Lange: Yeah, yeah.
Charlie Smith: Quantitative easing is the actions of the U.S. Federal Reserve, and actually central banks around the world now, using newly created money to buy government debt, and also mortgage debt. But mostly, in the past year or so, it’s been government debt. And that is, the Fed writes a check and purchases a U.S. treasury bond in the open marketplace, and then holds it on its balance sheet. So, what’s happening essentially is the Fed is buying up U.S. debt, and the proceeds go into the reserves at the banks, and the banks really have not been lending these newly created reserves out all that aggressively, and that’s one of the reasons economic growth has really not picked up all that much. But QE is essentially a way of creating more capital for the banks, more liquidity for the banks, keeping interest rates low, and forcing investors to take more risk. Instead of owning a treasury bond paying five percent, the Fed has driven rates down to three on a long bond, so investors have to go out and find a more risky investment to earn the income that they need. So, QE1, the first tranche of QE back in late ’08, early ’09, was really needed to support the economy. I think it really was something that the Fed recognized that they needed to do to support the banking system directly. QE2, QE3 really have not done a whole lot for the economy.
As I said a few minutes ago, economic growth in this recovery has never gotten beyond the three percent threshold, and the Fed keeps talking about the wealth effect, you know, the idea that creating all this new money in the system, driving down interest rates, driving up bond prices, driving up stock prices, is creating new wealth that somehow trickles through to the economy. Yes, there’s some of that, but it hasn’t trickled through to wages. Real wages are lower than they were fifteen years ago. So, QE2 and 3 really have not done a whole lot for the economy. QE1 helped support things during a period of crisis, and I think it was necessary. The second and third tranches of QE really have not done a whole lot for the real U.S. economy.
Jim Lange: All right. One of the things that you like to talk about, and I consider you an expert on, is…and I guess this is maybe an area where the private sector and the public sector have some collisions, is some of the pension liabilities, and I guess we can include both private companies as well as public governments, and a potential problem with unfunded pension liabilities, and do you see that as a major problem both in the private sector and in the public sector?
Charlie Smith: On the private side, much less so than five or six years ago. One of the sort of arcane principles of pension funding is that when interest rates fall, an entity that’s providing a pension has to put aside more money for beneficiaries. And so, as interest rates have been driven down by the Federal Reserve, public entities, whether they be police forces, firemen, county employees, city employees, have seen their funding needs rise. Also, because mostly in the latter part of the nineties, early part of the last decade, we saw benefit levels pushed up aggressively. Many cities, counties around the country were very generous with their benefit promises during that period, and now, you combine these generous promises with the need to fund a greater amount because interest rates are so low, it’s created a problem, particularly in the public sector.
On the private sector, the promises generally haven’t been as great, and on the private side, as well, pensions tend to own more stocks so that their returns have been a little bit better. But in the public sector, in particular, the funding problems in many cases are severe and continue to be severe. I was just reading this week about some of the problems in Illinois, and particularly in the city of Chicago, with their school pensions, their firemen and police pension system being funded only to the tune of twenty and thirty percent of potential liabilities. It wouldn’t surprise us to see the state of Illinois being asked to rescue some of the pension funds in the city of Chicago, and the state of Illinois is in just as bad shape as Chicago, in many cases. So, it wouldn’t surprise me to see some states coming to the federal government eventually for some sort of a bailout for some of these pensions that are just terribly underfunded.
Another aspect of this is that many of these plans are using very aggressive return assumptions on the assets that they have invested. The city of Pittsburgh, some of the plans in this area using annualized return rates estimates for the future of seven and eight percent annualized from portfolios that are maybe only seventy percent stocks and thirty percent bonds. Just two aggressive estimates of what kind of returns these pension plans are going to be able to generate, but they don’t want to have to ask taxpayers for a tax increase to fund these generous pensions, so they keep hoping that they’re going to somehow get an eight percent rate of return when it’s really not realistic.
Jim Lange: And I’m going to repeat a disclosure that I did early in the show. I’ll try to do it quickly, in that I am not independent with regards to Charlie Smith and Fort Pitt Capital Group. I do have an arrangement with Fort Pitt Capital Group, as well as a group that uses index funds, whereby our firm does some of the strategic work like Roth conversions, Social Security, how much you could spend, tax planning, retirement planning, and what we call running the numbers, and Charlie and his firm and, accordingly, the index firm, actually do the money management. The combined fee is one percent or less, depending on how much money is invested, and there is a split of that fee between Fort Pitt Capital and us. So, if you did like what you heard with Charlie and you go through our company, I do feel honor bound to say that yes, I would have an interest in you working with Fort Pitt Capital for full disclosure.
Anyway, Charlie, you were talking about the interest rates assumption that, let’s say, Chicago used, and I think you mentioned, like, seven or eight percent. Now, the way I’m thinking about it is, there is some blend between stocks that maybe really can’t be counted on for more than seven or eight percent, probably even less, and fixed income that might be one or two percent. Now, you have, let’s say, an average of maybe four or three-and-a-half percent, and that’s before cost, and so after cost, maybe a more realistic range might be, say, three percent…
Charlie Smith: Absolutely.
Jim Lange: …and then you’re using seven percent, and you’re basing your current funding on a seven percent assumption, then you’re going to be seriously underfunded. Is that correct?
Charlie Smith: Absolutely. You just laid it out all right there. Think of it this way: the broader interest rate environment, because of Fed policy and the slower rate of growth in the economy, interest rates have been coming down basically within the economy for thirty years. And so, the expected future rates of return from financial assets have been coming down, as well. Stock market returns will follow interest rates over time. So, the entire interest rate structure within the economy’s been coming down, yet the return assumptions that some pension plans have been using have been lagging far behind that decline. So, we have cities and counties all around the country that are using rates of return that are just not realistic in an environment where rates are continuing to be very, very low.
Jim Lange: And though we do have a national audience, mainly for streaming listeners, we also have quite a few local people, let’s say in Pittsburgh and Pennsylvania. Do you have an opinion on the rates that either Pittsburgh or Pennsylvania uses for its assumptions? Because just actually, I think, today in the news, there was an issue of people doing lots and lots of overtime in their last three years…
Charlie Smith: Absolutely.
Jim Lange: …and bumping up the base for which they will receive. But even forgetting that, what about the interest rate assumptions?
Charlie Smith: The rates of return assumptions…politicians really are going to always try to push off the pain of going to the constituents and saying, “Hey, we made a promise for a level of pension benefits that we cannot afford.” So, we’re going to use a little bit of an aggressive assumption about our rates of return, and from what I know about the city of Pittsburgh, in their plans, something in the seven percent-type return is what they’re using. So, they do tend to come down with a lag, a significant lag, and if anything, you need to ask your local elected officials to be realistic, because if they’re not being realistic, you’re going to be surprised, and they’re going to be bad surprises, and in our business, in any well-run business, the only kind of surprises you want are the good ones.
Jim Lange: Well, I don’t think Pittsburgh’s in trouble because our infrastructure and our sewer system are so sound that they won’t need a lot of money in future years.
Charlie Smith: Oh absolutely, Jim. Absolutely.
Jim Lange: All right. The other thing (and I know Jane Bryant Quinn sometimes calls it Harvey the Rabbit because we don’t see it) is the fear of inflation.
Charlie Smith: Yeah.
Jim Lange: And people have different views on inflation and what they can expect and what they should fear, but I thought you’re a little bit outspoken and don’t necessarily go with the rest of the crowd. So, can you give us your view of inflation and what we might be able to expect in the coming years?
Charlie Smith: Well, if you remember, back when the Fed started quantitative easing, the first tranche back in late ’08-early ’09, when gold prices really began to run up, there was an assumption that because the Fed was aggressively creating new money to buy these bonds, that inflation was right around the corner and that we were going to see something pretty rapidly akin to what we saw in the mid to late seventies, you know, the CPI running at a five, six, seven percent annual rate of increase almost immediately after QE began. It didn’t happen. So, there were a lot of people that sort of were discredited by the fact that their predictions for an inflationary blossoming right after QE started just didn’t happen. So, the way we see it, there’s not going to be the big spike up in inflation until we get wages rising. And even then, it may not happen. But generally, inflationary forces need the cycle of wages cycling through prices and then cycling back through wages again, you know, the old wage price spiral, to really take hold, and as I said a few minutes ago, the wage levels within the U.S. economy are stuck where they were fifteen years ago.
Jim Lange: Well, I always remembered that everybody else was running around fearing inflation, and you were not.
Charlie Smith: No.
Jim Lange: And time has proven you right.
Charlie Smith: And because we didn’t see the credit engine really getting going. The banks were taking in all this newly created money from the Federal Reserve, but they weren’t lending it out. Up until the middle part of last year, bank loan growth was averaging less than three or four percent a year. It’s picked up significantly in the past year or so, but we’re still not anywhere near back to levels that we were pre-2007, where bank lending was growing at double digits. On an aggregate basis, in the U.S., bank lending is still growing maybe six or seven percent. So, we’re not going to see that inflation until we see bank lending really growing, and then that feeding through into capital spending, greater corporate investment and wage growth, and the signs that that is happening, we’ve seen a little bit of an improvement in wages. The employment cost index has ticked up really since Thanksgiving. We’re starting to see a little bit of that, but the evidence is still sketchy as to whether we’re ever going to get this inflation cycle going again.
Jim Lange: All right, and is that really more of a national thing, or, let’s say in western Pennsylvania, particularly with Marcellus Shale creating a lot of new jobs, I’m going to be doing this workshop in Washington County, and I think that you can’t even find a place there. You can’t even rent a place. In a way, it’s booming with a lot of new jobs. Or is this more of a national issue that the local ‘job market’ isn’t going to be as important?
Charlie Smith: I think that, in the aggregate, wages are just not growing. You’re going to always have pockets where wages are doing well. For example, if you’re a highly-skilled welder and you want to travel to the Gulf Coast where they’re building all sorts of new chemical plants, you can earn a hundred bucks, a hundred and fifty, two hundred dollars an hour as a welder. If you have a specialized skill in certain technology areas, your wages are rising way faster than just about anybody. But if you average it all out, the aggregate statistics are showing that wages in the U.S. are basically flat and have been for fifteen years.
Jim Lange: Well, one thing that I think some clients say is, “Well, we’re a little bit afraid of the stock market. The interest on any kind of fixed income instrument, whether it be a CD or a bond, is pretty low. Well, maybe I should buy some real estate.” And I’ll, let’s say, separate it into two categories: one might be real estate where they have some personal management. Maybe they buy an apartment building near their home, or they buy a duplex and live in half. It’s, let’s call it, partly investment and partly actual manual labor. As opposed to, let’s say, a real estate investment trust, or a real estate investment in which they don’t have a personal management interest. What would you think, let’s say, both historically and today, would be the advisability of a real estate investment, and do you include that in your portfolios?
Charlie Smith: We do not. We’re believers that a local expertise is absolutely necessary if you’re going to be successful investing in real estate. One thing I would caution people about today is investing in REITs for yield, because they have been one of the most popular segments of the stock market the last five or six years as people have seen the Fed driving down interest rates, aggressively reaching for cash yield because of low rates elsewhere. So, the REIT sector of the market has really been picked over and has really done very, very well. If we do begin to see interest rates rise, the folks that have gotten into real estate investments on the assumption that they wouldn’t see the principle value of their investment decline are going to be in for a rude awakening. So, if you’re investing in real estate strictly owning a publicly traded REIT for the yield, be aware that the principle value of your investment can decline and decline considerably and wipe out whatever yield advantage you might get. So, that’s one caution I would give. For folks that believe that inflation is going to come roaring back? I believe that there are ways that you can own real estate as a wonderful substitute for gold, for example, as a hedge against inflation. We don’t happen to believe it’s going to happen, but if you believe that inflation is going to be running at five or six percent within the next few years, there is certainly a place in your portfolio for either direct equity ownership of real estate, whether you own a property that you manage yourself, or maybe an REIT.
Jim Lange: One last point, and I think we’re only…we have about three minutes left, so in three minutes, and I’ll even let you pick the topic, but asset allocation or rebalancing. We didn’t really talk much about that today, and frankly, that’s one of the things I think that Fort Pitt just does a fabulous job with…
Charlie Smith: Thanks.
Jim Lange: …both for me personally and for our mutual clients. Could you make a comment on what you’re doing? And I’ll give you the choice of either rebalancing or asset allocation.
Charlie Smith: Well, asset allocation really is a fairly straightforward process for us. Ownership over time, that is equity, is going to generate the most value for you as an investor. There’s nobody on the Forbes 400 that made their money by lending in a non, very levered way. It’s ownership that builds wealth over time. Now, the returns from ownership don’t happen in a nice, neat, straight line the way they do with a bond or a CD. But the returns, over time, are always greater. If the returns from ownership aren’t greater than the return from lending, that means interest rates have to fall. So, the asset allocation decision from our perspective, if you’ve got a horizon greater than five years, you need to have your assets in stocks. Now, if you’re going to have a need for cash flow within a three-year period, you need to slice off some portion of your portfolio and make sure your cash needs are met for the next three years, four years, whatever it is. So, the asset allocation is a pretty easy one. As far as rebalancing, don’t do it too often. We rebalance our asset allocation portfolios once every year-and-a-half to two years, and frankly, we probably would like to do it even less than that.