Dear Valued Clients and Friends,
When earnings season becomes more enjoyable to watch than your own political party’s convention event, you know that your priorities have probably been improved. It has been a crazy week, but not because many of our stock holdings have released disappointing Q2 results (quite the contrary), but rather for many other reasons from Cleveland to elsewhere. As I type this Thursday night, the markets are actually flat on the week, but that doesn’t quite tell the whole story. (There are some big winners and some big losers already out of earnings season.) Read on as we think there are some great, foundational charts here worth your time. Let’s get into it …
Watch this week’s Video Executive Summary at this link (unique content).
Listen to this week’s Dividend Café podcast at this SoundCloud link or this iTunes link (same content as this writing).
- Through Thursday evening, the market was basically flat as a week.
- If oil prices are heading south again, why are high yield bond prices linked to oil companies not saying so? This relationship between credit and oil prices is important to watch.
- Earnings season is looking quite strong so far, but we emphasize, so far.
- The worst performing asset class in the last few months (or right up there) is Cash. Investors playing market timing games have missed out on tremendous returns in almost all risk assets, but then also get forced into making a second bad timing decision.
- MLPs have not seen the prices investors will pay for their yields (relatively speaking) due to the same that other yield-heavy sectors have (Utilities, REIT’s, etc.).
In the News This Week
- The Republicans completed their convention in Cleveland with the expected nomination of Donald Trump. It would be too hard to exhaustively commentate on all that transpired in this space. It was, shall we say, an interesting convention.
- Mario Draghi announced that the European Central Bank was doing nothing new for now, but presented a handful of strong hints about being “ready and willing to act further,” which is to say, further negative yields, purchase more bonds, and generally weaken the Euro currency where they can so as to effectuate their monetary weaponry.
- China – Their 6.7% real GDP growth rate for Q2 was impressive. (It was +8.4% nominally.) But so much came from the housing boom and construction, that as those numbers decline into the future, there will likely be an acceleration to the growth slowdown. Private-sector investment has continued to slow. Their trade-off between avoiding a bubble and maintaining growth targets is a wacky needle to thread. So far, waters are still. So far.
- Oil – With prices having dropped 10% from the $50 range to the $45 range, it is fair to question if oil prices are getting ready to roll over again. One noteworthy argument against such is how differently high yield energy credits are acting this time around, whereas last time the collapse in oil prices seemed to forecast a flood of bond defaults. This time, at least so far, credit markets appear to be saying “we’re not worried about oil prices dropping much further.” Of course, these things are really, really in flux!
- Recession – We are firmly in the camp (and have been for a long time) that the U.S. is in a “muddle through economy,” which is to say, not recessionary, and not in impressive growth mode. It is tepid, lackluster, and cool, but it is net positive, which means by definition, not recessionary. The manufacturing outlook is moderate. Consumer behavior is flat. Housing starts are solid. Unemployment is low. Wage growth is anemic. So it is a mixed bag, for now.
- Earnings – Though just around 20% of companies have reported results so far, earnings season can be credited with extending this rally, or at least not yet dampening it, as over 70% of companies have beaten earnings expectations, and even 57% of companies have beaten on the top-line (revenues). Last quarter less than 50% exceeded revenue expectations. Plenty of company results to come …
Questions from Readers
- We know you are raising a little bit of cash, here and there, just as dry powder, in your client portfolios. Would you consider taking a meaningfully high cash position ever, like 30% or 40%?
It is noteworthy that in the big post-BREXIT rally that ensued, U.S. stocks made all-time highs, the Japanese NIKKEI went up 10%, bond prices rallied hard, and yet gold rallied as well. In other words, the only way to have not made money these last few weeks was in, well, cash. And this speaks to the reality of market timing. Going into the next phase of market action, where there is a lot of global uncertainty, negative bond yields, challenges for hedge funds, and frothy stock valuations, the reality is that cash simply guarantees a 0% return (a negative one with inflation), and exposes people with excessively high cash positions to the atrocious dilemma of when to come back into risk assets which rallied while they were out. It is a terrible position to be in, and keeping cash positions light and tactical is the best way to avoid it.
- What do you think of the Schiller P/E as a way to measure stock valuations?
Professor Schiller says average earnings over full cycles serve as a better metric because of corporate profit volatility, and while that idea sounds compelling, the execution of his actual metric (when back-tested) has led to some rather self-defeating results. It does us no good to create a metric that says the market is “always over-priced.” By definition, it can’t always be over-priced, because, well, hopefully you don’t need me to go any further. Many academics have discovered flaws in his formula (this would belong in the deep, deep, deep end of the pool) that expose the flaws in rationale, but we do not use Schiller’s CAPE measurement as a useful tool in evaluating stock valuations.
- When do you think the continued froth in high dividend stocks will fall out of favor?
We wouldn’t dare to put a day, week, or month on it, but substantively, we think it will be when valuations bubble over, or when bond yields rise and spreads compress to the point that it no longer makes sense. We see low yields and low growth on the horizon for quite some time, meaning there should continue to be appeal in this sector of stocks (yes, even to the point of excessive valuation).
Deep End of the Pool
If this sounds redundant, forgive me. I want everyone to understand this basic tension we are dealing with in capital markets, and I promise you this won’t be the last time I go through it. Essentially, the Fed is in a desperate need to somewhat normalize monetary policy or they risk severe distortions in our own capital markets. However, they are stuck in place by the extraordinary conditions around the globe that have resulted in negative yields in Europe, Japan, etc. If the Fed tightens our monetary policy, the dollar will rally, and our risk markets will sell off, and that will reverse the effects they are going for – period. There is not a simple way out of this, and their delay in normalizing is making things worse. But the complexity and tension comes from this issue – how to normalize when everyone else is doing the opposite.
Weekly Reinforcement of a Permanent Principle
Historical charts tell us how things turned out, so when there are bad periods that we visualize on a chart, we are also seeing at the same time the subsequent recovery out of a given volatile period. When we are actually going through a volatile period, though, there is no chart showing us the happy ending. Our faith is being tested. And the worst (and most expensive) words in investing history often get uttered – “what if this time it’s different?” So we are sympathetic to those whose faith in their own long term strategy gets modestly tested with each new bout of volatility; but we are not, and simply cannot be, sympathetic with those who succumb to that test. Feeling bouts of fear is normal when investing in risk premia assets; giving into that fear is fatal.
(Please note, risk premia is the fancy term for what we are doing on behalf of clients – buying assets that offer a premium over the risk-free rate of return, and thereby carry more risk than that which is risk-free).
Comments from the Bull in Us (What We Like)
It is no secret that we are big fans of the MLP model, meaning, oil and gas pipelines that pay attractive dividends to investors at a tax advantage, and seek to grow that income year over year as volumes of oil and gas that run through their pipelines increase (and particularly as the number of projects they have moving oil and gas increases). This business model has been in place a long time, and performed remarkably well for investors who want attractive income and attractive growth-of-income, but it has been subject on several occasions to significant downside volatility (where the prices of the company stocks suffered large declines, even as the income they paid out did not!). 2008 was a great example of this MLP volatility, as was 2015. True to form, 2009 was a huge recovery year for MLP’s (strongly extended into 2010), and likewise 2016 has so far been an impressive rebound for a space brought under much distress by the oil collapse of 2014/15. Our exposure here has helped our 2016 results, but frankly we can’t help but notice that the yield spreads with MLP’s are still very, very wide over historical levels (whereas with most other yield-heavy sectors, they have dramatically compressed). In other words, in a day and age where superior income matters a lot to investors, they are still being gun shy when it comes to this sector. The events of 2015 have left people scared, and while prices are higher, and lessons have been learned about the volatility embedded in the space, the yield levels say that there is room to go. Funding still matters (to afford growth), as does distribution safety, but we are bulls.
Comments from the Bear in Us (What We Don’t Like)
When a company believes the greatest use of shareholder capital is stock buybacks vs. robust dividend payments, we think there often (not always) are less-than-stellar motives at play (bonuses tied to earnings-per-share, for example), and we think that the delayed monetization extends and expands risk. Many companies do both, and do so robustly (high free cash flow generators), but we are bearish on those who are suddenly devoted to buybacks, often with borrowed money, and those who shun the discipline of dividends to shareholders.
Switching Gears (Outside the World of Investments)
We will make few decisions in our planning that are more important than who will serve as successor trustee to oversee financial affairs when you are gone. Whether it is using “Uncle Jim”, and family friend, or a corporate trustee, there are numerous considerations that are very important when one is conducting estate planning. We have a lot of experience in this planning, and encourage you to reach out to us for any counsel or conversation that may be useful in guiding or revisiting your own decision.
Chart of the Week
Clients and readers should know that I am appropriately cautious and skeptical about much of the present market condition. With that said, I found this chart simply irresistible. At least there is some humor to be found in all of this.
Quote of the Week
“Here is the trade off with diversification: You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.”
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It really has been an interesting week. Please do enjoy your weekends, enjoy the summer outdoors, and may your stock holdings be filled with robust dividend growth, from which all sensible and reliable investment returns flow.
David L. Bahnsen, CFP®, CIMA®
Managing Director, Partner
Chief Investment Officer
Brian T. Szytel, CFP®
The Bahnsen Group, HighTower