Dear Valued Clients and Friends,
We entered the second month of 2019 this week and as of press time have continued the upward trend. There hasn’t been anything dramatic in markets this week and both upside and downside volatility has really subsided (for now). I use this week’s Dividend Cafe to provide a summary of January’s market action, and to walk through a handful of topics that I believe you will find to be a lot more thrilling than that Super Bowl game was. There also is a much meatier-than-normal emphasis on Politics & Money this week, so for you incorrigible political junkies jump into that section as well. Off we go to the Dividend Cafe …
Dividend Café Video
Dividend Café Podcast
January redux
The S&P 500 closed the month of January up 8%, and up 15% since its low point on Christmas. Emerging markets were up 9% in January, and small-cap rallied over 11% on the month. Oil’s $10 per barrel increase meant a nearly 20% move for the month, maybe the most under-reported story of January.
One of the more interesting things to note about January and the huge stock market recovery is that Technology was not the leading sector. Tech moved higher, no doubt, but whereas last year’s January rally saw Tech represent 50% of the move higher in the market, Tech only accounted for 17% of the rally this year (despite representing 26% of the S&P 500 by weighting).
The leading sectors for the month were Energy, Industrials, Communications, and Financials (more on this “sector talk” below). Utilities were the worst-performing sector at just under 1% to the upside.
The bond market was up just shy of 1% (Barclays Aggregate Index), though the municipal index was up less than that.
It was hard to find an asset class not in positive territory in the month of January.
What’s not to like?
For one thing, I actually can’t stand how bullish people have gotten. Dividend Cafe readers can never forget the deep contrarianism that runs through the DNA of The Bahnsen Group – that while unhelpful for timing, sentiment is often a reverse indicator of where markets will end up going. This philosophy confounds many of our clients when deep levels of pessimistic sentiment become very enticing for us. But the same is true on the other side, and while there exists plenty of negative sentiment that we like (primarily the deep levels of cash still being held on the sideline), the reverse to more bulls than bears so quickly is not something we like.
Does this strike you as counter-intuitive? If so, I understand. But at the core of the philosophy is the belief that, generally speaking, with no thought to what it means in a day, a week, or a month, that generally feels the hardest to do is usually the best, and what generally feels the easiest to do is usually the worst.
Holy jobs number!
Yes, the 300,000 jobs for January was far above expectations and does indicate continued economic growth and expansion. But without trying to be the wet blanket, the 300,000 figure from December was revised downwards to 220,000, so there was some offset in there in the rolling numbers. Wage growth is staying steady, impressive, and nowhere near inflationary, at 3.2% year-over-year. You add to this jobs data the impressive PMI Manufacturing number from January, and the economic outlook continues to look strong.
I will not become a full-blown economic bull until I see that the capex number is moving in the right direction, driven by business investment. But right now, should the trade war fears get out of that way, I really do believe that will happen, and GDP growth will continue in its upward trajectory.
Do you like Santa Fe Springs, California?
Our investment holdings right now have heavier weightings in the financial, health care, consumer staples, technology, and energy sectors. Why do we like those sectors so much?
We do not in fact “like the Financial, Healthcare, Consumer Staples, Tech, and Energy sectors right now.” We do not dislike them, either. I have no opinion on any sector, ever. We do not buy sectors; we buy companies.
There are portfolio managers who are referred to as “top-down” – they start with countries, sectors, etc. and work down from there. I am what is called a “bottom-up” manager. I am buying individual companies on their own merits for clients, and our philosophy is that individual company dividend growth drives returns and creates virtuous cycles. This distinction is not semantic; it is foundational.
I may love some company in Santa Fe Springs, California as a company. But that would not follow to “I like Santa Fe Springs as an investment opportunity” – and it actually wouldn’t have even necessarily followed that “I like consumer packaging companies.”
There is another problem, and that is the problem of “specificity.” We actually gather our overweight in Financials from ASSET MANAGERS, and then one INSURANCE company. To refer to a top-down sector like financials often implies “big banks” – which we actually like our one “big bank” holding, DESPITE it being a big bank (not because of it).
Now, at the end of the day, one obviously does end up with an incidental sector allocation, and we do want to manage the risk created out of that sector allocation (ceilings on sector overweights, for example). But we are bottom-up investors seeking equity risk premium from individual operating companies – and to that end, we work.
Keeping it private …
We do not talk about the private equity asset class much in the Dividend Café, yet we are heavy investors in such at The Bahnsen Group. Its lack of liquidity and income generation limits the base of investors it may be appropriate for, yet there is much to like about the asset class where all circumstances are appropriate for a given investor.
Our Managing Director of Solutions and Analytics, Deiya Pernas, recently attended a roundtable on the asset class, and took away some key findings that are worth sharing:
- Listed stocks (in the public equity markets) are half of what they were twenty years ago (from ~8,000 to ~4,000 today).
- IPO volume is down 89% since the mid-’90s (obviously there was a dot com boom twenty years ago, but still, less and less highly investible companies desire the pastures of public markets – for a lot of reasons).
- When 11% of the public stock market is in four or five companies (FANG), you know that index investing has gotten very concentrated.
- Buyback levels in the public markets indicate a decreasing commitment to capex, where private companies represent the great fertile opportunity for such productivity-enhancing investments
The inherent advantage to private equity – illiquidity which renders obsolete the noise of market volatility – has always been what I find most attractive. I desire to find great operational companies to be invested in, and those exist in private and public equity markets. The liquidity of public markets provides a multiple expansion, but it also forces investors to be exposed to a truly silly level of noise and sentiment. The concern with private equity, though, has always been its reliance on borrowed capital, and the valuations paid to generate deal flow. Right now, I am really interested in the level of dry powder many private equity firms have, and what this bodes for long term returns into the next stage of the economic cycle.
An update from MLP land
Otherwise known as “Master Limited Partnerships,” the term “MLP” hardly covers the “oil and gas pipeline” sector any longer as so many companies have converted out of the partnership tax structure to the more conventional C-corp business formation. I spent a lengthy amount of time studying the quarterly results from some of the leading MLP names this week, and it is interesting that even some of the largest players are investing a conversion to C-corp, yet are citing the uncertainty of the benefits as a factor in the delay. For one thing, few seem convinced that the new 21% corporate tax rate (down from the previous 35% rate) is really going to prove permanent. And there is understandable ambiguity as to whether or not the C-corp status would really broaden the investor base as much as discussed.
I think the biggest reason some of the big, high-quality players may not move forward with conversion to a new corporate model is that they may not need the funding any more than equity sale represented. They now self-fund capex from cash flow and have managed their leverage very effectively. This sector is a powerful proof of leadership names improving their standing via good decisions.
Adding to the argument for energy infrastructure
I have been making the argument to all who would listen for several years (and believe me, I am merely reaffirming the argument many others far smarter than I are making) that the U.S. is under-prepared in term of infrastructure (pipeline, storage, ports, etc.) for the changing of the guard in global energy needs. I remain convinced that the opportunity around oil (and gas) exports alone are one of the major economic stories of the next ten years.
Source: MLPGuy.com, CBRE Clarion Securities, Extending the Value Chain, Feb. 6, 2019
But in all the focus around U.S. export terminal needs, it is worth understanding the opportunity on the receiving end of the equation as well. Are global customers prepared to receive imports of oil and gas? If not, what is the investible opportunity here? Expect more on this in the months ahead.
The data point of the week
One fascinating thing caught my eye this week: Stock buybacks reached $800 billion last year, and will likely reach the same this year, and yet only 14% of stock buybacks were financed by debt in 2018. That is far less than half of what it was the year prior!
Fed watch
U.S. commercial banks were, in fact, tightening lending standards in the fourth quarter of 2018, something that is highly likely to have correlated with the Fed’s tightening of monetary policy. With the significant amount of demand in the levered bank loan market and additions to financing in that space, the bank loan market has become an important bellwether for overall credit markets and general economic conditions. Will the Fed’s recent reversals put the brakes on what has been a marginally tighter move in commercial bank lending? I suspect it will. And is that perhaps the very reason the Fed has reversed course? I suspect it is.
A thrilling explanation of emerging economics
Very few things require the caffeine of the Dividend Cafe more than a discussion of emerging markets currencies, but there is a point I wanted to make that some of you may stay awake to read. I talk a lot about the short term impact that the U.S. dollar has on emerging markets, and it is important to understand why this is. When a country that has borrowed money in U.S. dollars has to pay it back with U.S. dollars that now cost more money relative to their own currency, it puts pressure on their own currency and heightens inflationary pressures in their own economy (a spiraling effect). To counteract that potential pressure, central banks have to defend their own currency, and the easiest way to do that is to tighten monetary policy, which puts pressure on equities, credit spreads, risk assets, etc. The ability to pay off dollar-denominated debt is impacted negatively when dollar liquidity is threatened. Ultimately, organic growth always wins out in the end, but organic growth itself can be threatened by these internal economic dynamics, which is why they matter with EM equities, bonds, and currencies. Our view is to be aware of the dollar impact on what we own, to manage that risk accordingly, and to focus on fundamental earnings growth in EM equities where dollar-denominated debt is less at play, and long-term values can be realized.
Politics & Money: Beltway Bulls and Bears
- The President gave his State of the Union address Tuesday night. It was a long but well-written speech and struck a very cooperative, conciliatory tone. The market didn’t respond much around the commitments to an infrastructure bill or prescription drug pricing because, well, the market doesn’t believe there is any way the Democrats will give this President a deal. The emphatic affirmations that the United States will never be a socialist country were nice to hear.
- There is no question that the President’s approval ratings and the empirical metrics around the economy are really disconnected. Growth has accelerated to roughly the 3% range, about double the annual trend-line growth realized over the eight years of the prior administration. Sixteen significant regulatory rules of the prior administration have been repealed. And while the tax reform that individuals saw in the 2017 tax bill was underwhelming as far as supply-side growth incentives were concerned, the corporate tax cuts were stimulative to business investment as I have argued time and time again for over a year. Average hourly earnings are up 3.2% year-over-year, a middle-class real wage hike that has been very elusive for a long time. And inflation has stayed quite muted, so growing wages are not being eaten up by higher prices. I remain frustrated by the tariff intervention but hopeful that a deal which puts that episode behind us is coming. All said, from wages to jobs to GDP growth to manufacturing to confidence, the economic metrics in the United States are, at this point, strong enough to be considered a political asset for the President.
- Is the bill from Bernie Sanders and Chuck Schumer seeking to ban companies from buying back their own stock a threat to investors? No, for the simple reason that it is going nowhere, and they know it. I, of course, am a dividend growth investor, and have no particular reason to defend stock buybacks, other than that I am an anti-statism, anti-totalitarianism American, who believes companies retain control over their own assets and the disposition thereof. And of course, investors, employees, vendors, and such all retain their freedom as well. Rational actors pursue the optimal allocation of capital. Period.
- One of the most interesting political disagreements centers around the impact of the tax cut on the economy. As this week’s Chart of the Week shows just below this, even the Congressional Budget Office (formerly very skeptical of the supply-side stimulative impact of the corporate tax reform) has re-indexed growth projections for the next ten years to the upside.
- What would create short term revenue to the government, reducing deficits, and serve as a stimulant to capital investment? Indexing capital gains to inflation, something many in the Treasury Department still believe can be done without Congressional approval (I agree). It would create an immediate unlocking of long-term gains which creates revenue to Treasury, and then also opens up capital to new productive investment. Just sayin’ …
Chart of the Week
Nominal GDP has now been upgraded by $7 trillion since the tax bill passed (and a new $750 billion in the last CBO report). We are one year into the tax cut, and thus far 1/3rd of the revenue lost from the tax cut has been recouped via higher growth.
* Strategas Research, Policy Outlook, Jan. 29, 2019
Quote of the Week
“We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.”
~ Warren Buffett
* * *
This felt like a more normal week in the markets, with a couple up days that were not dramatic and a couple down days that were not dramatic, and earnings results creating very different company-specific outcomes (as it should be). I confess as a bottom-up stock fundamentalist to being fond of this environment, though we are not fully there yet. The less macro drives outcomes and the more micro does, the better (as far as we are concerned). Macro is less volatile right now with the Fed’s newfound idle position, but China, trade war, Europe, and GDP growth still loom large.
We remain steadfast in our positioning from both a risk and reward standpoint: Keep equity weightings level to your natural strategic allocation, slightly underweight fixed income (bonds), and overweight alternatives (where non-correlated risks and rewards can be found).
Enjoy your football-less weekend, and reach out to The Bahnsen Group any time, about anything.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
