Barron's Streetwise - STRIPS Strategy for Safe Money. Plus, Big Small Caps and Bear Talk

Episode Date: March 22, 2024

Listener questions answered, with some Grambling on about March Madness and why coin flips aren’t 50/50. Learn more about your ad choices. Visit megaphone.fm/adchoices

Calling all sellers, Salesforce is hiring account executives to join us on the cutting edge of technology. Here, innovation isn't a buzzword. It's a way of life. You'll be solving customer challenges faster with agents, winning with purpose, and showing the world what AI was meant to be. Let's create the agent-first future together. Head to salesforce.com slash careers to learn more. So we're going to be answering a few listener questions. Is that the idea, Jackson? That's the idea.

This is the Barron Streetwise podcast. I'm Jack Howe. You're Jackson Cantrell. You're our audio producer who will be listening in with us. And what kind of topics are we going to get to? There was one on small caps, small cap indexes. One on a three to five year time horizon for a cash need. And bears.

The bear case for the stock market, I take it. Bingo. Okay, well, my bear case involves actual bears, but I don't want to give too much away. give too much away. Are you filling out a March madness bracket? Oh yeah. Are you trying to win something? Cause this one, one of the sites that they'll give you crazy amounts of money. If you have an accurate bracket, I think I'm automatically entered into the website ones, but I have one with my extended family every year. Yeah, I got you. This is for people who don't follow sports. It's time for the big college basketball tournament. They call that March Madness. And there's a 64 team tournament

and people fill out brackets to try to predict the winners. And it was 10 years ago that Warren Buffett famously offered a billion dollars for a perfect March Madness bracket. I don't know if Buffett is still offering money for the bracket challenge. I think that there's just a contest that he now runs for Berkshire Hathaway employees, but don't hold me to that. There is something called the Zero Right Bracket Challenge, and that's from Pepsi. something called the Zero Right Bracket Challenge, and that's from Pepsi. And they're using that to promote, I guess, their zero sugar drinks, like Pepsi Zero Sugar and Mountain Dew Zero and so on, Mug Root Beer Zero.

And the idea is you want to fill out and you want to get everything wrong. You try to get zero right filling in your bracket. I didn't know I was playing that game this whole time. You could have done well. I thought it was just really bad. The question is, can you keep doing poorly if you try to do poorly? I did see something that I want to share with you about the odds of getting a perfect bracket. Of course, it's an absurdly high number. This is from NCAA.com, and it comes from a sports journalist named Daniel Wilco.

And people have said before that the odds of getting a perfect bracket are one in nine quintillion, which I guess is why Warren Buffett offered the billion dollars for that, because he can do math and knows that that's something that's never going to happen. But the chances are not really one in nine quintillion. That would be if your odds of picking any game were even odds, just like that of a coin flip. By the way, story for a different day, the odds of a coin flip are not what you think, because coins have different things on either side of them. And the metal used to make like the head on one side of a coin is just slightly like infinitesimally heavier than the other side. So if you actually flip a coin,

it's not really a 50-50 chance. Did you know that? Lincoln does have a big forehead. There was a study. If you're really interested in this subject, there's a 2007 study that you can curl up with. It's titled Dynamical Bias in the Coin Toss. Anyhow, back to the bracket. coin toss. Anyhow, back to the bracket. So a one in nine quintillion chance if each game is a 50-50 probability, but of course each game is not a 50-50 probability, right? To the chagrin of our Grambling State fans out there. Well, come on. Don't count out Grambling State. So it's one in nine quintillion odds if every game is a 50-50 chance, but many of them, especially in the early rounds, are far from 50-50 chances. There was,

on the women's side, right, there's the South Carolina team, which is undefeated this year. It's just a powerhouse team. I mean, they just win and win and win. And they're going up against a team that just got into the NCAA tournament for the first time. And that team is called Jackson, uh, Presbyterian Presbyterian. Right. And you know, I wish them the best of luck. I don't want to, I don't want to be a denominational split after this game. Let's see. But your chances of predicting the outcome of that game are far better than 50-50. Okay.

So we know that the probability is going to be better than one in nine quintillion. And it turns out that over at NCAA.com, they've done some of the math. There's a guy at Georgia Tech, a professor, his name is Joel Sokol, and he has created a statistical model to predict the outcome of college basketball games. And he says it's gotten to the point where it can guess correctly about 75% of the time. And he figures that if you can do that consistently in the tournament at the end of the game, your chances of getting a perfect bracket drop to somewhere between 1 in 10 billion and 1 in 40 billion. So those chances shooting higher. But the average person who fills out a bracket is not going to be as accurate as that statistical model. NCAA.com has done the numbers on people that have filled out brackets with them over the past five years. They looked at first round selections and they looked

at the differential in the seedings between the teams. And anyhow, they calculate a 66.7% accuracy for a typical game. And they say, if you use that instead of 50-50, if you have that chance of success, your odds of a perfect bracket are about one in 120 billion. So you're telling me there's a chance. There is a chance. If every person in the U.S. filled out a bracket every year, this is again, according to Daniel Wilco over at NCAA.com, you would expect to see a perfect bracket sometime within the next 366 years.

I mean, we got to figure out how to live that long too, I guess. Now that math, I know what you're thinking is of dubious value to anyone trying to make money. And you're right, but it's actually a little worse than you're thinking because by the time people hear this, Jackson, they will already have filled out their brackets, right? I mean, probably. By the time people hear this, Jackson, they will already have filled out their brackets, right? Yeah. I mean, probably. So tuck this away for a year and then re-listen.

It's what you call neither actionable nor timely. But I like to think that it has whetted our appetite for some of the discussion of stocks that is coming up right now. Who do we have for our first listener question, Jackson? Yeah, we have Josh. Just Josh. That's going to make his bio easy on Twitter. Anything else you want to tell us about, Josh? I was looking for a state or city or something, but I'm drawing a blank here. Well, Josh, while I don't know everything about you, I've got a good feeling about this question. Let's hear it. Hey, Jack and Jackson, love the show. So I have a three to five year time horizon for a cash need. And it's a long enough horizon that I'm willing to take a bit more

risk than just parking the cash in treasuries, but definitely not long enough for me to want full exposure to the equity market. So my question is, how would you recommend I allocate this money today? Is it as simple as just allocating a small percentage to an S&P 500 ETF and keeping the rest in treasuries? I have looked at some alternatives, namely direct lending, but those funds are A, hard to get into, B, definitely more opaque, C, expensive, and D, just feels like I'm getting away from my financial nudist self, so to speak, aka unnecessarily complicated. I appreciate it. Hey, Josh, thanks for your question. And thanks for the shout out to Financial Nudism, which is the name that we've given on this podcast for a minimalist approach to investing, keeping it simple. I am going to mention something here called STRIPS, which sounds like it could fit into

a nudist approach, but it's an acronym. It has to do with treasuries. It's probably a little more complicated than you need, but I think it'll be helpful for illustration. I'll tell you in a moment. Okay, let's start by framing the question. You say three to five years. I'm going to call it five years just to make my math easier here. And does everyone out there know how to find treasury yields for various maturities? If you have a favorite financial data service, that might have them, but you can also get them from treasury.gov. There's a page that's titled Daily Treasury Par Yield Curve Rates, and that's

got all of them. Okay, so for five years, it shows me that a 10-year treasury was recently yielding four and a quarter percent. So that's kind of the baseline of what you can make without taking any risk. But it turns out that the shape of the yield curve right now is a little wacky. You can get higher rates on shorter maturity. So at one month, you're at 5.5%. At six months, about 5.4% and so on. So if you put it all in a five-year treasury, you'll get a lower yield. If you put it all in a one-month treasury, you'll run the risk that the rate to reinvest at after that month is up is lower than what you got initially. So you can create a blend. I'm going to guess it wouldn't be too hard to get about 5% on your money between now and five years from now.

So you can do better in stocks. As you say, historically, the average return per year there has been closer to 10%. There are just two complications. First complication is the stocks don't always go up. Here's an analysis from B of A Securities. They say, if you look at S&P 500 total returns since 1929. If you held the index for one day, your odds of losing money were 46%. So even if you're only investing for a day, there's better than even odds that you'll make money. That's what stocks do.

They increase in value over time. Now, don't invest for a day. If you can hold out for three months, your chances of a loss shrink to 32%. At one year, you're down to 25%. And at five years, you're down to 10%. If you go all the way out to 10 years, you're down to a 6% chance of a loss in that stock portfolio. So, okay, five years, 10% chance you'll lose money. I don't know all the details of what you have planned for that money, but let's say that that chance of loss is just unacceptably high. You don't want to put all the money in stocks. Then there's a matter of whether right now is a typical starting period. We're going to talk a little more about this later in the episode, but suffice it to say that stock

valuations look high. And so when that's the case, you're not quite sure what the returns are going to be like later this year, but you can make not quite sure what the returns are going to be later this year. But you can make some educated guesses about what they're going to look like on average in coming years. Northern Trust, as one example, has a financial model for this year where they predict that over the next 10 years, the average returns for the US stock market will be 6.3% per year. So lower than typical. And that's because the starting point for valuations

is higher than typical. I should also point out that investing is not physics, right? These are not laws. These are observations based on the past of human behavior. It doesn't necessarily mean that these probabilities are going to hold true going forward. Does that make sense? I mean, Jackson, if you climb up a ladder and you drop a bocce ball,

the rate of acceleration for that ball is going to be? I can't remember. It's 9.8 meters per second squared is gravity. And I think acceleration under gravity is like 4.9. I don't know why I'm thinking you have to divide it by two, but something like that. 9.8 meters per second is correct. I know I sound like a know-it-all, but I'm a know-it-almost-none on that subject.

It's just that that number is like stuck in my head since high school. I don't know, 9.8 meters per second squared. And then you've reached it. Eventually, if it's a high enough ladder, you reach a terminal velocity where the something matches the something else and it begins falling at a steady speed. Okay. I'm glad we covered that. Anyhow, that's predictable, right? And the things that I'm talking about are not laws of physics.

They are not like, you know, they're good probabilities. That's about it. Okay. So now I'm going to tell you about a way to come up with your own answer about what to do and what kind of percentages might be right for you. Does everyone know what strips are? They're sometimes called zero coupon bonds. I was unfamiliar. Strips stands for separate trading of registered interest and principle of securities.

That name doesn't exactly roll off the tongue and strips are more complicated than ordinary bonds, but they're not super crazy to understand either. Let's say, Josh, that we're talking about $100,000 of a U.S. treasury that's going to come due in five years. In five years, you would expect to get your $100,000 back. You'd also expect to get some interest payments along the way. Those are called coupons. Those work out to that four and a quarter percent per year. And you get paid twice a year. Now, it turns out that with some financial engineering, you can take that bond and you can strip it. You can break it apart into different elements. One of those elements is the principal, the part that says you get a hundred thousand dollars five years from now.

the principal, the part that says you get $100,000 five years from now. The other part is the payments. That says you get this little payment after six months and this little payment after 12 months and this little payment after 18 months. And so on a five-year bond, there's going to be 10 of those payments. So you take the 10 payments and you take the one principal value, that works out to 11 pieces of money. Pieces of money that you know you're going to get at some future date. And if we know that you're going to get a piece of money at some future date and we know what prevailing interest rates are, we can calculate how much you should pay today for those pieces of money. You got it? It's going to be less. You're going to want to buy them at a discount, and then you'll have more money when they

come due. So when you strip bonds, you end up with what's called a zero-coupon bond, because it doesn't pay you a coupon payment along the way. You don't get those interest payments. You buy it at a discount to its maturity value, and then the value gradually rises as you get closer to maturity, and that's your return. And there are zero-coupon bond calculators on the internet that can help you with some of the math.

If you were buying $100,000 worth of a bond with five years to maturity, where the interest rate is going to be 4.25%, you'd pay a little over $81,000 for that bond today. You got it? So you pay $81,000, you know you're going to get $100,000 back. I'm rounding here. it. So you pay $81,000, you know you're going to get $100,000 back. I'm rounding here. Doing that might mentally free you up for thinking about what to do with the other $19,000. If you're starting with $100,000 and you know you're going to get $100,000 back after five years and it's only costing you $81,000 to get that guarantee, you've freed yourself up to take some risk with the $19,000.

Even put it in the stock market. Even knowing that there is some non-negligible, some meaningful chance that you could lose money over the next five years. A better chance that you could make money, historically speaking, but it's not a sure thing. Now, there are a few complications with strips. I don't want to get too far into the weeds here, but one is that even though they don't

pay you interest each year, they are taxes though they do. There's something called imputed interest. It's no fun to pay taxes on money that you haven't actually put in your pocket that year. Some people don't like zero coupon bonds for that reason. They're also more volatile relative to interest rates than coupon bonds. The reason why is a little mathy, but if you're definitely going to hold the bond to maturity, the price volatility between now and then, if interest rates change, doesn't matter. The third complication might be the least attractive thing about strips, and that's that

you can't buy them on the same low-fee platforms that you can for regular treasuries. You can buy regular treasuries from Treasury Direct and keep fees very low, but strips have to be created by financial firms. And those firms can tell you about the pricing, and they can also build fees into those bonds. Sometimes it's hard to know exactly what you're paying in fees. But I think the strip math is useful for thinking about just how much of that money you're comfortable putting at risk. In this example, you could just as easily buy $81,000 worth of regular treasuries that pay coupons, and then you can put $19,000 into the stock market. And that's the best advice that I

can give you about how to think about how to frame the risk return trade-off. It's not magic. You're not getting something for nothing. And if you absolutely must have every penny of that money plus every penny of their return on that money five years from now, then you should stick with treasuries and forget about the stock market altogether. And of course, there's a much bigger investment world out there than just this choice I've described. You're going to have to decide for yourself. Do you want to take a little bit more risk with some very high quality corporate bonds for some higher return on that money? Do you want to, instead of protecting 100% of your principal using that strip bath to create a bond

strategy, do you want to protect 80% of your principal and take a little more risk in the stock market? You'll have to decide those things for yourself. Good luck, and I hope that helps. Jackson, I'm exhausted. We're one question in. I know we want to get to three. Do we take the break here? I mean, I did the whole, I wasted all that time with the March Madness. I got into some financial engineering. I need a breather. I think we could take a break. But I'm going to rally soon. I'm going to pour a zero sugar cola. Won't say which brand. And I'll fill out my loser's bracket.

That's the spirit. We'll be right back after some quick words from these lovely people. welcome back jackson i know that you've been flipping coins to test what i said about the probability earlier what are you up to four four million to ten heads is heavier let's get to another listener question who do we have we have mindy from colorado hey jack love your podcast i'm a new listener uh my name is mindy and i'm from arvada colorado uh quick question so i'm listening to your s&p 600 podcast and you're talking about small caps which i I think are great. My question is, say you invest in like an index fund, small cap, and you know, one of your small caps ends up growing to a mid cap or a large cap. So what happens? Do they exit out of your fund

because it's classified as a small cap or do they move to a bigger fund? I don't know. It's confusing. Anyhow, any guidance on that would be greatly appreciated. Mindy, thanks for the great and timely question. I'll tell you why it's timely in just a moment. The answer to the question is pretty simple. These indexes are managed by companies that rebalance them typically once a year. And when they do that, companies that have gotten too large for those indexes, they graduate to larger indexes. You go from small cap to mid cap or from mid cap to large cap. Now I could stop there, or I could go on to answer a question that you didn't ask. And I think we all know which one it's going to be. It's kind of my whatever the opposite of a superpower is.

So here's something you didn't ask for, Mindy. I'm looking at a story by my pal at Barron's, Andrew Barry. It's from February 16th of this year, and it's titled Supermicrocomputer is the only stock that counts in the Russell 2000 index this year. The Russell 2000 is small and mid-cap stocks. Supermicro Computer is a company that used to have a humble valuation, but it has run up like crazy on the artificial intelligence boom. If Jackson had told me six months ago to put all of my money in this stock like he should have,

then I'd be up 1,662% right now in just six months. Andrew pointed out in his story that Supermicro's market value was about $50 billion, and that was five times the size of the next largest company in that Russell 2000 index. He also noted that the average company in that index had a market value of only about $1.5 billion. So Supermicro is sure to be booted at the next rebalancing if its market value stays even close to this high. It was, as Andrew pointed out, larger than 72% of the companies in the S&P 500 index. That's a large company index. This is meaningful for investors because you know how strategists and analysts have been saying for

the longest time that value stocks are due for a bounce back and small caps are due for a bounce back. Well, they've started to say in recent months that small cap stocks have begun their bounce back and they look cheap relative to large caps and they're likely to continue shining from here. Maybe so. But as Andrew points out in his story, one company, Supermicro, is by far the largest contributor to that recent outperformance by small cap indexes. So what remains to be seen is whether small caps can continue shining even once their brightest star has gone. And that is what I like to call an over-answer. I think for you, that was mostly on par. Who do we have?

We have time for one more, right, Jackson? What are folks asking about? What do they need to know? We have Garrett, who's 22, from Fayetteville, North Carolina, and he asks about the bears. The answer is, don't tell me, make a lot of noise when you're walking through the woods and you can carry pepper spray, but it's easier to just make sure that you're not the slowest guy in the group. Maybe we should listen to the question first. It seems like

everyone is a bull in this market. Where are the Bears estimates for the S&P in the back half of 2024? Thank you. Bye. Thanks for your question, Garrett. The bears, of course, say that stocks could fall for the rest of the year. I mean, that's kind of what makes them bears. I think that there's something to that. I don't like to predict the direction of stocks in the near term, or I should say I just always guess up because that's what stocks do most of the time. But I'm eyeing that stock market valuation and it's starting to look a little bit, what's the word here, Jackson? Tall.

Tall. I was thinking scary, something what's less scarier than scary? Worrisome? Stomach tumbling. Okay. Think it over. Let's just point out Jackson is not a trained gastroenterologist. I'm barely a trained wordologist. Garrett, I spoke with a strategist at a big investment firm the other day who told me that they were constructive on the market. Have you heard that term before? I don't know what it means. If someone could tell me, please do. I know what bullish means and I know what bearish means. I think constructive is what you say when, as was the case for this firm, when you have a price target and the market has already

caught up to your price target. And so technically you're predicting no more upside for the market, but you don't want to come out and tell people that you're bearish. You don't want to quite say you're bullish. So you just say we're constructive. So when you say everyone is bullish, I think there are people out there who are having difficulty coming up with an explanation for why they should still be bullish. My explanation is simple. I just stay invested in a mix of stocks and bonds for the long term. There are plenty of examples historically where stocks were expensive to start and they went on to become more expensive. So it's very hard to predict the short-term direction of the stock market. Here's some numbers to think about. I looked recently at the earnings estimate for this

year for the S&P 500 and the index was trading at about 22 times this year's projected earnings. I think that's quite high. There's always a question of what is typical, and it kind of depends on what historical time period you use. But I think 15 or 16 times earnings are typical for stocks over the long run, so I think they're pretty pricey right now. One possibility is that stock valuations could come down. The spread between the earnings yield for the stock market, that's what you get when

you take that PE ratio, you flip it upside down so that it's an EP ratio and you express it as a percentage. That's a little over 4.5%. It's about 4.6%. And that's very close to what you can get on the highest quality bonds right now. When the spread between the earnings yield for the stock market and bond yields is that tight, it's one sign that stocks might be a little overvalued. So maybe the market could fall

and the price earnings ratio could move lower. Again, very difficult to predict. One other thing that could happen is those earnings estimates could prove out to be higher than the earnings we actually get. This is a tricky one to figure out because what happens every quarter is companies beat their earnings estimates. We know that. But what also tends to happen leading up to each quarter is that Wall Street lowers its estimates for earnings to beatable levels. So it becomes very difficult

to look at a whole year's earnings estimate and figure out whether that's what we're actually going to get. When I look at the consensus estimate on FactSet, it tells me that earnings for this year are projected to grow by 11% from last year. Is 11% earnings growth feasible? Eh, maybe not. One way to tell is to break down that annual figure and look at the individual quarterly estimates. Now, the earnings growth estimate for the first quarter of this year is 3.9%. How do you get from 3.9% growth for this quarter to 11% growth for the full year?

I'll tell you how. The earnings estimate for the fourth quarter of 2024 is 17.5% growth. Now, is that because analysts have sat down and thought out the matter carefully and decided, I think 17% earnings growth looks likely in the fourth quarter of 2024? Or is that because they've just stuck a placeholder number out there, haven't really done any hard thinking on it yet, but as we get closer to the fourth quarter, they'll begin reexamining their math and bringing down their earnings estimates. I've got to believe it's the latter.

As they bring down those estimates and then companies beat those estimates and we do that for all four quarters this year, what do we end up with? Maybe it's not quite 11%. I want to point out one last thing, Garrett. There's a note out this past week from our friend Jonathan Golub over at UBS, and it's titled Big Tech Rally on Borrowed Time. We know that stock returns have been driven recently by the biggest U.S. tech companies. They call them the Magnificent Seven, although Tesla stock is kind of tumbled. So nowadays, people talk about the big six, Apple, Amazon, Alphabet, Meta, Microsoft, and Vidya. Jonathan points out that performance for those companies has been

backed up by earnings. If you look at the fourth quarter, earnings per share growth for those companies was 68%. He says that's a little distorted because in the same quarter a year earlier, there was a 26% earnings decline, so there was a lower base. But the bigger issue he points out is that going forward in 2024, the biggest driver of excess returns for these stocks, earnings momentum, is expected to rapidly decelerate. Now, that's a problem if the thing that's been driving these great stock market returns sharply decelerates. On the other hand, he thinks that earnings momentum for companies outside of tech will accelerate. So maybe the other companies can help make up for some of the lost oomph. Garrett, if you're at all a typical 22-year-old, stay invested.

Resist any temptation to try to time the market. Work hard, save hard. The world is going to look remarkably different by the time you are my age. I was your age in 1994. No laughing, Jackson. Jackson, you know what the largest companies in the S&P 500 were back in 1994? Take a guess at number one. General Electric? I don't know. Not quite, but it's on the list. I'm going to run through it. Tell me how many artificial intelligence slash dot com names you hear here. Exxon Mobil was the largest, followed by Coca-Cola, Walmart, Raytheon, Merck, Procter & Gamble, General Electric, PepsiCo, IBM, and Johnson & Johnson.

It was all oil, soda, and missiles back then, I guess. Now it's machine learning. And my point is, Jackson, I got a point in here somewhere. Tie a bow on this for me. You know, if you buy an index, those companies will change, but you'll make sure you have a piece of it. I don't know. I like it.

I like it. You say it with a little more conviction. Come on. All right. But Garrett, thanks for your question. Best of luck. I also want to thank Mindy and Josh. I hope everyone is in great shape on their March Madness brackets. Garrett, thanks for your question. Best of luck. I also want to thank Mindy and Josh.

I hope everyone is in great shape on their March Madness brackets. And thank you all for listening. If you have a question you'd like answered on the podcast, just record it using the voice memo app on your phone and you can email it to me. I'm at jack.how. That's H-O-U-G-H at barons.com. That's it. See you next week.