Barron's Streetwise - Should You Pay Off the Mortgage Early?
Episode Date: January 5, 2024Plus, bond investing for small fries, the 60/40 rule, and what to do when the Buffett indicator flashes red. Learn more about your ad choices. Visit megaphone.fm/adchoices...
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Brand spanking new year.
And Jackson Cantrell, our audio producer, has something to tell us.
Jackson?
That's a great cold open there.
Emphasis on the spanking.
It's our 200th episode. that sounds like a shocking number um if we were to
compare that would say fire up google for me look up how many episodes they did of um let's say alf
for people who don't know that's a 1980s sitcom about an ordinary American family joined by a little furry, sarcastic alien.
Jackson?
102 episodes.
Nice.
We've hit double ALF levels.
Not bad for a show that we started basically the week everyone got sent home for the pandemic.
And this is a part where we drop the party streamers and the balloons, and the marching band comes through,
and we announce our very special slate of guests. But it of only kind of snuck up on us yeah right frankly kind of just
kind of just realized all of a sudden it's a bit of a holiday week a short week and we had
planned to do well we're going to do some listener questions we're going to answer some listener
questions even better some might say our listeners are better than any guests we could have rolled out. Well, let's, let's not pander.
They're, they're way too smart for your pandering and a good looking, might I add, who's up
first for our questions?
We've got Doug from Iowa.
My financial advisor is worried about a recession.
Muhammad Al-Erin recently said on wall Street Journal's Take on the Week podcast,
he's worried about a 2024 recession too. The Buffett indicator is a metric I recently learned
about, and it says even with the recent pullback, the U.S. markets remain 30% overvalued. Can you
explain the Buffett indicator to listeners and offer your perspective? Are you worried if Muhammad
is worried? I hope your voice has recovered and appreciate your show. Thank you, Doug, from Iowa and go Hawkeyes and or Cyclones,
depending on whether you're an Iowa or Iowa state man. You asked about recession and valuations.
Let me take those in order. I think the chances of recession, there's always one coming, of course, but will we
have one in 2024? Maybe the chances are receding a little bit. I saw a beginning of the year note
from Goldman Sachs, and they said the coast does look clear for the U.S. economy. They point out
that the 10-year treasury yield, it was up over 5%. Now it's back down below 4%. And the Federal
Reserve is widely expected to pivot from
raising interest rates to lowering them. Goldman's economists expect to exit 2024 with GDP growth of
2%. U.S. stock valuations do look concerning. The S&P 500 is back up to about 20 times earnings.
That's high, historically speaking.
I would say the average, depending on which data set you're using, which time period,
which measure of earnings is somewhere in the neighborhood of 15 times earnings.
You mentioned a Buffett indicator. That's where you take the value of the entire stock market
and you divide it by gross domestic product or the size of the economy in the US. It's basically
whenever you have a valuation ratio, it's usually a measure of the size of the economy in the U.S. It's basically whenever you have a
valuation ratio, it's usually a measure of the price of something compared with either what
accountants say it's worth or the economic productivity of it. So price to book value,
that compares the price of a stock with what the accountants say that company's assets are worth,
none of its debt. And price to earnings, that's a comparison of the share price of a company with
how much
earnings per share that company can generate in a year.
And the Buffett indicator is kind of the same thing, just for the entire economy.
You compare the value of the stock market with the economic output in a given year.
And when you look at the Buffett indicator, just like when you look at the P.E. ratio,
it says things are expensive.
the Buffett indicator, just like when you look at the P.E. ratio, it says things are expensive.
I recently saw the Buffett indicator stood at 175 percent and that that ranked as significantly overvalued. Historically speaking, that suggested that returns from here for the stock market are
likely to be below average. And that's really the rub here. We can say that things are expensive.
That doesn't necessarily mean that stock prices are set to fall right
away.
The market could continue rising for some time.
Earnings could outperform expectations, and that could give some support to stocks.
It's really hard to time the market and say, hey, things are expensive now, so I'm going
to bail out here and I'll buy back when things are cheaper.
It's easy to get burned trying to time the market doing that.
The best thing an investor can do is say, the market looks expensive now.
Over the next 10 years, it's reasonable to assume that returns will be lower than I've come to
expect. I'd better save harder or I'd better reduce my spending expectations going forward.
I hope that helps answer your question. By the way, you asked about my voice.
I think I'm turning the corner on it. Thank you. I had that thing where you're like sick for two days and then it takes you eight weeks for your voice to come back, but
starting to feel a little better. How do I sound Jackson? How's my, how's my timber?
Timber is great. Smooth and clear. Good. Thank you. Let's have another question.
This one comes from Jeff in South Carolina. of money in the stock market each month, but want to start investing more in the bond market as well,
even though I know how crazy the bond market is right now. My understanding, though, is that most
bonds are very expensive, or at least beyond the amount I'm able to invest in. Any advice on how
to invest in the bond market for a small-time investor like myself? Thank you, and keep up the great work.
Great question, Jeff.
When you hear you should have, I don't know, 30% in bonds, 40% in bonds, what have you,
how do you actually get that percentage?
What do you buy?
Do you buy individual bonds?
Do you buy funds?
Jeff, you mentioned that buying individual bonds would be expensive, as you say, and you don't mean valuation.
You mean it takes a lot of money.
Single bonds often have a face value of $1,000. You're not going to buy just one bond. You don't want to pay too much
in fees for your trades. You're going to buy, I don't know, 10, 20, 30 bonds. That's 20 or $30,000
just for one issue. Now you have to buy a bunch of different issues to diversify, and maybe that's
just your corporate bonds. What about your government bonds? What about overseas? I tend to think of a million dollars as a starting point for a properly diversified bond portfolio.
If you're investing less than that in bonds, maybe well less than that in bonds, you have a few choices.
Unit investment trusts or UITs are for investors who want the diversification that you get from a big bond portfolio.
They want it with a smaller dollar amount and they want to have a defined portfolio.
They want bonds that come due at a certain date.
They know when they're going to get their money back.
The other option is a mutual fund of some sort.
There are open end funds.
There are closed end funds.
Increasingly, there are exchange traded funds for bonds.
Closed end funds are kind of a special animal that can trade at a premium or a discount
to the value of the underlying bonds.
We'll talk about those another day.
Open-end funds and ETFs are similar in that the value of a share price more or less tracks
the value of the underlying bonds, although the mechanics are a little different.
Now, the big decision to make is index or active.
With the stock market, you can buy into an index like the S&P 500, or you can buy an actively managed fund where there's a professional out there who picks stocks. And we've talked for a
long time about how difficult it has been for active managers to beat the stock market. And we generally mean large cap US stocks, the S&P 500. So I think money has poured into S&P 500
funds because investors figure, look, the fees are low on these funds. Active managers mostly
don't beat the S&P 500. There doesn't seem to be a lot of downside here. It's a little different
when you're talking about bonds. With a stock index, the companies are weighted according to the stock market value of the
company.
So as companies become more successful, they get a higher weighting in the index.
With a bond index, the bonds tend to be weighted according to how much the issuer has borrowed.
That's not quite the same thing as success.
So the most heavily weighted entities in a bond index tend to be
those that have borrowed the most, which maybe that's not what you want.
Now, the good thing about a bond index fund is that the fees are very low.
How low are we talking about, Jackson? We're talking, for example, the Vanguard
Total Bond Market ETF. BND is the ticker on that one.
Has a fee of 0.03%.
You take the elevator all the way down to cheap.
You get out, you go down two more flights of stairs, and that's where you end up.
0.03% is mighty cheap.
And they have $302.4 billion of assets under management.
Cheap and popular.
Now I'm going to read from a Barron's item that was published last August. This is from Lauren
Foster. She writes about new options that are popping up for actively managed bond ETFs.
And she pointed out at the time that in 2022, half of the actively managed bond ETFs outperformed
their Morningstar category.
And last year at the time of this story, about two thirds of this growing pool of actively managed bond ETFs had beaten their indexes.
So the numbers there are much better than they are for large cap U.S. stock funds.
The story mentions two relatively new bond ETFs from companies that are massive players
in active bond management.
bond ETFs from companies that are massive players in active bond management. One is from PIMCO,
and it's called the Multi-Sector Bond Active ETF, and the ticker there is PYLD. The manager of that fund oversees a massive amount of money for the firm, including in its flagship fund, which is
the world's largest bond fund, PIMCO Income. The ETF was relatively small at the time of this story.
And the manager points out this is not a clone of any particular strategy.
It's just the bond team looking for the best yield-oriented strategies.
Another fund the story mentions is BlackRock Flexible Income.
That's another ETF.
The ticker there is BINC.
Here again, the manager oversees trillions for BlackRock.
That's the world's largest asset manager. And this ETF, the story says, is investing in harder
to reach fixed income sectors, such as high yield bonds, emerging market debt, and securitized
assets. Now the fees on these funds are around a half a percentage point. It's 0.55% for the PIMCO one and 0.4% for the BlackRock fund.
So well above the level of that Vanguard bond index, but lower than you see in a lot of
active management where fees can top 1%.
Here's one way to frame your decision.
That Vanguard total bond market ETF has 46% in treasury and agency issues and
another 20% in government mortgage-backed securities. So in other words, the fund gives
you about two-thirds exposure to the U.S. government. Maybe that's what you want and
maybe it's not. If you want to go for active management in your bonds and you don't want to
get walloped too badly on fees, one option
is to do the treasury portion yourself. You can do that quite cheaply. You don't have to go to a
broker or buy existing bonds where there may be markups built in. You can go to treasurydirect.gov
and buy bonds on the auction. You don't know the yield ahead of time, but you get whatever the
market rate is and you don't pay any fees.
And the minimum investment is low. So you can either ladder some bonds with the money coming due each year or so, or you can use a barbell approach, buy something short, like a one or
two year treasury combined with something longer, like a 10 year treasury. Then you pair that with
the active fund of your choice and those free treasuries pull your overall expense ratio
lower. And that is how to create a pretty diversified bond portfolio without a ton of
money and while keeping fees fairly low. I hope that helps, Jeff, and thanks for your question.
Jackson, this has been an action-packed listener question special so far,
and I think you know what time it is.
Marching band?
If by marching band you mean a parade of helpful information
from our podcast sponsor, then you're right.
We'll be back right after this break.
Is the break over? That's it, right? Ready to ready to go it's over yeah okay we're ready
i'm gonna get some post-break enthusiasm in my voice a little razzle dazzle this is uh
this is how you make it to 200 episodes you gotta really you gotta
welcome back to the big Listener Questions special.
I think we've got time probably for one or two.
It depends on how fast I go.
I think we'll do two more questions.
Jackson, who do we have next?
We have Mark from Birmingham, Michigan.
This is a written question, so there's no audio.
So I'm going to paraphrase it and do my best Mark impression.
Does it start off with any praise? Sometimes people... Yeah, yeah, yeah.
That part, you hit word for word.
After that, you can sum it up.
Okay.
Hi, Jack.
I love your podcast.
One of the things I like most about Fridays is the newest edition of your podcast.
Some people are calling it the best thing about Fridays.
Go ahead.
Mark mentions the 60-40 rule and wonders if a different rule can
make better sense depending on an investor's situation. He says he keeps three years worth
of living expenses in cash. Then he has seven years worth of living expenses in a bond index fund and the rest in equity funds or stock funds. And that brings him
closer to 80-20 than 60-40. And so he was wondering if that makes sense as an investment strategy.
Thank you, Mark. So the question is about the 60-40 portfolio. That's the classic example
of the stock and bond mix because you want that long-term growth, but you know that the value of
your stock holdings can go up or down sharply in any given year. So you need something to help
smooth out those returns. You put the 40% in bonds, the returns there over time are not expected to
be quite as high, but your bond holdings will hold their value better in any given year. They'll be less volatile.
Okay, so as you say, Mark,
you can certainly dial those percentages up or down according to your individual circumstances.
We've talked in the past in this podcast
about Warren Buffett
in a letter to his Berkshire Hathaway shareholders
when he outlined the instructions given
for the money he leaves to his wife
that it be put 90% in an S&P 500 index fund and 10% in treasuries.
And I guess he meant that to say that, you know, he's a big proponent of indexing.
You can do just fine there.
But I think it also serves as an example of how
your age is not the key thing that should determine your mix.
Warren Buffett is an older fellow, so if we were
only going by age, you might say, well, he should have 70% in bonds. But of course, Warren Buffett
is also preposterously wealthy. So the chances that he's going to fall on hard times because of
a downturn in the stock market are nil. And that's really what you have to protect against. That's
the whole purpose of the allocation, to protect yourself against the event that you don't have enough money at some point in the future when you need it.
So the richer you are, the more that you can afford to put in stocks, all else being held
equal. Also, the less you can live off of, the more you can afford to put in stocks, all else
held equal. If you're the breadwinner for a young family and you might need to use this money at some point several years from now, then you better keep a pretty
conservative asset allocation. If you're a single person living out in, where are you, Jackson?
Joshua Tree National Park? I'm here. Living off the land. What do you do? You're roasting
armadillos out there. What do you do? That's illegal. That's highly illegal.
That's the desert. Yeah. Leave the armadillos alone. I don't know what they have out there, but
maybe you're not the best example. But anyhow, the ability to live leanly and having fewer people who
depend on you, that's another thing that allows you to be more aggressive in your investment
approach. Mark, I don't know exactly what you have in your mix, but I like the way you're discussing it.
You're talking about having a certain number of years worth of money that you can fall back on if you need to, which allows you to invest the rest of your money for growth.
I'm guessing that your 80-20 mix is just fine for you.
Jackson, I was so quick in that question, even with the Armadillo part.
I think we have time for another.
Yes?
Definitely.
This one comes from Conrado.
Let's hear it.
Hey, Jack.
Long time listener.
First time asking a question.
Love the show.
Hey, I have two questions, actually.
So I have four properties.
Three of them have mortgages with interest rates below 3%. And the fourth one I just bought has interest rates
of 7.35%. This last one I bought, I bought it because I'm relocating for work. So two questions
that I have. The first one is, what's your latest take on real estate as an investment?
And the second question is, I'm going to receive some bonus this coming March, and I wanted your opinion about paying off some of the mortgage on that
fourth house, the one with the 7.35%. Thanks, Jack.
Thank you, Conrado. I'm not sure that I have a blanket opinion about investing in real estate.
There are pros and there are cons. If we're talking about buying real estate that trades
publicly like stocks, in other words, real estate investment trusts, I'm of the general belief that
you don't really need them as part of your asset allocation. The regular stocks you own represent
companies that already have real estate. Some of those companies are even REITs in the funds you
might have. So you probably already have real estate exposure through your stocks but i also don't think it's particularly
harmful if you're an investor who wants to buy a sliver of REITs for income now you're talking
about buying individual properties and that's just so highly localized i don't know what types of
property you have i don't know what the cash flows on them look like generally speaking managing
property can be a lot of work, so it's not for
everyone, but it also allows you to use a tremendous amount of leverage, which could be a
great thing for building up wealth over time. Some of the wealthiest people on earth have made their
money in real estate. Your second question is more straightforward. Should you pay off your mortgage
that has an interest rate of 7.35%? In a word, yeah, probably. You
have to ask yourself a few questions. Number one, are there any fees associated with paying off your
mortgage early? Sometimes there are in the first few years. If so, wait. Number two, will paying
off the mortgage early put you in any kind of bind financially? In other words, will you have
two little funds available in case you need them? The third question then is, can you do better on a different investment?
You basically treat your mortgage like it's a bond, 7.35%, but you might be getting some
tax breaks on your mortgage interest.
If so, that 7.35% for you is the equivalent of something lower.
You're going to have to do that math yourself.
Let's say it's the equivalent of six and a half percent on your mortgage. So the question then becomes, can you do better than
six and a half percent elsewhere? And before you say that you can make 10% long-term in the stock
market, just remember that we have to account for risk. Stocks are risky, returns there are
volatile. Your mortgage rate, if you're treating it like a bond, is an
absolutely pristine credit. There's nothing in this world that's a better credit than you paying
yourself with your own money. So the question really is, can you do better than six and a half
percent on something that has next to no risk? Probably not. So it's probably a good idea if
you have plenty of funds available to pay down that mortgage early. Of course, I'm making some generalizations here. This will really depend on your individual
circumstance. You might be someone who has an appetite for risk and a tremendous number of
attractive investment opportunities available to them. So you might see something out there where
you can earn a double digit return. And yes, it's riskier than this, but that's an amount of risk that you're willing to take on.
What do you think, Jackson?
Did we answer Conrado's question?
Yeah, definitely.
I always feel like there should be a mechanism.
Maybe this is a horrible idea.
I feel like there should be something out there for people.
He says he has mortgages with rates below 3%.
And then he has one at 7.35.
So I'm assuming that's a more recent purchase. If you have a rate
locked in, let's say for 30 years under 3%, the bank would certainly much rather have you paying
more than 7%. There ought to be a product or a mechanism available by which you can say to the
bank, hey, dump X amount of cash in my account in exchange for the right for you to refinance
my mortgage and give me the new market rate, whatever it is, 7% and change. Don't you think
then you could, it's a way for people to tap cash and then, you know, and then they just have it.
That's how it works in the bond market, right?
That's how it works in the bond market. This would just allow for market repricing of that mortgage
before it hits the securities market. This would just allow for market repricing of that mortgage before
it hits the securities market. Probably people would abuse it and get themselves into hot water
financially. It also sounds like an awful thing. It's a more difficult sell than a reverse mortgage.
It sounds like you're doing something horrible to people, but there might be people out there who
say, you know what? I could use that cash right now. Let me put that in my account. Maybe someone will make that product.
I think the low rates of the past are keeping a lot of people from selling their homes. And
that's why you've seen so few, I guess, movement in the real estate market. And it's hard to find
homes that are available. Right. So you say, turn this three percent mortgage into a seven percent mortgage dump 80 or 100 000 into my account and now i'll be free to sell my house
and to move on to another house that would help maybe unstick the housing market we've solved
something big here today what should we call this new financial product probably the conrado the
conrado thanks for the idea conrado and I want to thank Mark and Jeff and Doug.
Jackson Cantrell is our producer.
He's filling in for Metta.
He'll be rejoining society next week.
Is that right?
Back from the desert to Los Angeles.
Back to LA.
And speaking of rejoining society,
we'll be back with a regular episode next week.
Probably sprinkle in some listener questions as we go. So keep
those coming, please. You can record on your phone,
use the voice memo app, and you can send it to
jack.how. That's
H-O-U-G-H at
barons.com. Anything else, Jackson?
Subscribe,
like. Here's a fun fact.
Next week we'll be totaling
201 episodes,
which puts us right in line with The Office.
Minus the enduring joy that it brings people.
Well, it's good to know just the same.
Thanks and see you next week.