Dear Valued Clients and Friends,
I give myself very good advice. But I very seldom follow it. Will I ever learn to do the things I should?
So goes the Kathryn Beaumont hit from 1951, Very Good Advice, in the classic Disney masterpiece, Alice in Wonderland. Why am I starting this week’s Dividend Cafe with a quote from Alice in Wonderland? Well, for one thing, my son Mitchell recently starred as the Mad Hatter in his school’s very impressive production of the Disney hit, so I guess my son was in my head. But more importantly, this catchy little song has a lot to do with this week’s Dividend Cafe …
We refresh the realities of human nature in investing this week, but we also dive into the fascinating subject of excessive debt, and what it means for the next 20 years of macroeconomic conditions. Since the China/trade issues were the story of the week in markets (and the cause of the reversal that we saw Thursday) we will cover what needs to be covered there as well.
I enjoyed writing this week’s Dividend Cafe as much as any I have ever written. Join me, and see what the fuss is all about.
Dividend Café Video
Dividend Café Podcast
Human nature a more powerful force than good advice
One of the reasons the financial advisor profession exists, at least as far as this fiduciary advisor is concerned, is to manage the behavioral tendencies of human beings who are subject to human nature. Whatever one thinks about investment management, portfolio construction, cash flow mechanics, financial planning, tax optimization, estate strategies, and any of the plethora of services and roles generally part of a financial advisory relationship, there is one primary function that is eminently relational, non-commoditizable, and value-additive – the management of an investor’s behavior. This management function is not needed because human beings naturally do what is right; it is needed because, left to the devices of nature, human beings have a strong (natural) proclivity to do what is wrong.
From the wishful thinking belief in easy (or free) money, to the capitulations to fear that dominate during bouts of market volatility, the shift from greed to fear and fear to greed is unending. And it is natural. And it is the end to which we work.
My continued epiphany
I do not think “epiphany” is actually the right word, because this concept has not “come to me” – as much as it is something I have been studying and grappling with and becoming more and more convinced of through research and analysis. It is important – because I think so many simplistic understandings suggest an opposite conclusion.
The subject is that of the impact of greater government spending on interest rates. We know that when a company borrows more and more money they become a riskier company to lend to, and the interest rate for their debt goes higher as investors demand more return to compensate for the risk of lending to them. Many assume the same should work for the government, and that is certainly true at first glance. But we have seen bond yields drop as government spending as accelerated, and we have seen it all over the world. Many assume it is merely central bank intervention that has caused this, but I no longer believe that is solely the case. If you believe that the government spending and debt overhang “crowds out” private investment (it does), and ultimately creates weaker economic conditions (it does), then it follows that loan demand would be reduced, putting downward pressure on rates.
Why does this matter? Because it suggests a very long-term period of relatively low interest rates, until such time that the private sector re-captures the portion of the economy that government debt overtook (which usually is never). Monetary intervention cannot always create the results we want in a free market (as free market actors are too smart and too unwilling to be manipulated).
It doesn’t stop there – in all thy reading, read this
If one believes that excessive sovereign indebtedness ultimately puts downward pressure on long term interest rates (as I do), it behooves us to ask if we believe excessive sovereign indebtedness is likely to persist. One argument is that excessive current debt means that future debt has to come down via austerity – and it is certainly true that mathematically appropriate fiscal policy (pro-growth measures that increase revenue and spending discipline) would lead to reduced indebtedness. But this is not about math, it is about politics, and there are very few nations on earth (most certainly including ours) where the political will and national appetite is there to reduce spending. Are you against the high levels of debt? I bet you are. Are you willing to cut $500 billion out of the national budget, and if so, what will you cut? Now you get the idea. The people have not yet said they actually want particular spending cut; just abstract spending. So economically, I have to presume that the debt will continue until some economic force makes it stop. And this is where investors need to perk up …
Ultimately, excessive debt has to be inflated away, yet debt burdens are inherently deflationary, which leads to a vicious cycle of central bank interventions. These interventions have been my primary macro focus for over 20 years, and will be for the next 20 years. The Treasury will ultimately look to the Federal Reserve, in my opinion, to monetize their debt (if you don’t see what has been done already as quasi-monetization). A macro view that fails to capture this framework in the decades ahead will make key errors in interest rate assumptions, growth expectations, and ultimately, asset allocation. Getting the framework right is the end to which we work.
The other side to the coin in my trade war fear
My primary fear remains that an unresolved trade war holds business investment down long enough that it becomes too late – that the capex renaissance needed to boost productivity into two or three more innings of economic expansion fails. But there also is a sense in which this perpetually “soon, but not yet” trade resolution is ironically good for the markets, and good for President Trump politically. Until a deal is struck, he can continue to bash China with political impunity (he scores well for it). And until a trade resolution is found, markets have some floor in place, because markets have to price in the potential of a deal coming. So a continuation of punting may actually hold markets in place for a bit (albeit with enhanced volatility), and it may serve the President politically.
But that certainly does not mean it can be done without damage to the global economy, and without damage to the U.S. economy.
Cause and effect?
One of the great coincident metrics to business investment and capex is what we are making in U.S. factories. Industrial production increased in a beautiful way throughout 2017 and the first half of 2018. We saw the number peak last summer right when – you guessed it – trade tensions began. It has steadily declined ever since and now sits at two-year low. Of course, we are talking about the growth of industrial production slowing, not an actual contraction (yet), but this is an example of the threat the trade war represents to the economic expansion.
I wrote several paragraphs of this week’s Dividend Cafe from my apartment in Manhattan early in the morning on Thursday, with CNBC on in the background as I worked. As I was typing, the futures had been pointing to a drop of 200 points in the market at the open (as of press time the marker was down 350). Assuming this holds, it would put the market in negative territory for the week (the market was up on the week entering Thursday morning). I have no idea what the market has done between the time I typed this and the time you read this, but my point is this: The voice on my TV has uttered the words “market drop” over twenty times this morning. The VIX is sitting barely around 16. The market is down about 3% since the trade war stuff began, and it is up 13-14% year-to-date. The melodrama events like this create is so incredibly non-productive for investors, if they let it be.
My advice until there is trade resolution around this China deal? Don’t wonder if there is volatility embedded in markets – assume there is. Don’t fret such volatility, hope for it.
Teasing you with fear
Besides, if someone wanted to provoke bouts of fear about markets right now, the one thing everyone on the planet is talking about (the fate of a trade deal with the U.S. and China) is hardly the only issue worth talking about. If markets surprise to the downside over the next 3-6 months, and I by no means am forecasting that they will, I suspect it will not be the mere playing out of this China/trade uncertainty (an event I fully expect to create up and down volatility until resolved) – but rather an exacerbation of distress in the utterly catatonic European banking system. Don’t get me wrong – it has been a dead man walking for years now, and I am predicting no particular catalyst to an acceleration of distress. But if one wants to worry, I would worry about what the press is not talking about, not what they are talking about. The European banking system is as good of a candidate as any for a surprise summer trauma.
A refresher on equity returns
There is a misnomer about stock prices that needs to be clarified. It is actually something I implicitly address almost every week in my constant reiterations that stock prices are discounting mechanisms – meaning, they are always pricing in now what they believe about the future. However, it needs to be explicitly stated what is implicitly true in that reiteration – and that is for a stock price to surprise us to the upside, it does not suffice for the company to be great; it must “be better” than what the stock price already discounted (i.e. already assumed). It can be said that a weak company which gets better will generate a better return than a great company that does great (because the stock price has already discounted what is great). As dividend growth investors, we want the stability and income generated from great companies, which is different than “unexpected pops” in stock price. We believe deep value can be revealed where a company has not yet discounted an improvement story that is yet to play out, but management with its dividend policy is indicating their own confidence in future execution.
The moral of this story is not that a secret formula can be found for stocks that will “pop” in value (it cannot). Rather, it is to pour water on the idea that the best performing stocks will be ones where everyone already knows of the company’s greatness.
Speaking of equity returns
Earnings season is essentially behind us, and earnings per share growth was, indeed, positive on the quarter (vs. a year ago). More importantly, revenue growth was up 5% year-over-year, stunning those who believed that the tax cuts were a transitory moment only for the bottom line. 76% of companies beat earnings expectations (earnings estimates had been revised downwards too much). 55% beat revenue estimates.
Where have all the high flying IPO’s gone?
2019 has thus far provided Exhibits A, B, C, and D for a point we have been making at The Bahnsen Group for long at least five if not six years – that large private companies are staying private so long now (for a plethora of reasons), and achieving needed liquidity and monetization in the private market so effectively, that by the time a company goes public and receives its liquidity multiple, the “growth” people formerly anticipated is simply already exhausted. In many cases, companies are actually going public at an initial level far above its sensible value, so not only is there not the “free money pop” of the late 1990’s, but in many cases, significant and immediate price depreciation. Two lessons are important here:
(1) It may be wise to look at why companies want to delay going public as long as possible. Perhaps it is never going to change, but would a regulatory re-conditioning relax this intense aversion?
(2) Individual investors should recognize how they are viewed in the supply chain by the large Wall Street investment banks allowing for this financial restructuring – as the suckers most likely to pay the thoughtless valuation at the IPO offering
The large institutional investors who formerly bought at the IPO are now accessing these deals well before the IPO. The fact of the matter is we have had two high profile IPO’s in the last fifteen years that have shot the lights out, and a dozen or more that bombed. The two I refer to were profitable companies at the time of their IPO, and have proven to be operational outliers. The rest are a mix of some fantastic companies and some not fantastic companies, but regardless, they are all symptomatic of the new reality in capital markets: Private enterprise is finding its path in private equity markets.
Checking in on housing
One of our 2019 themes at the beginning of the year was that housing was likely to “re-price” – not a major “crash” by any means, but a healthy adjustment where warranted – a softening of what had gotten overheated. On a year-over-year basis, monthly existing home sales have declined now 13 months in a row. Prices are not in freefall, but the time it takes to sell, and the volume of what is selling, have absolutely declined on a national basis. Ultimately, are these dynamics better understand in local markets? You bet!
Is a Fed rate cut coming?
The Fed’s minutes this week didn’t say anything to increase or decrease those odds, but I believe the odds are slowly increasing. The Fed is staking their argument for a still stasis in monetary policy (no hikes, no cuts) on the idea that, yes, inflation has dropped, but yes, it will be back up to 2% or higher in short order. I do not think that is why they are hesitant to cut; I think it is because they fear that a lower rate would just re-accelerate growth in the leveraged loan market, heightening sensitivity in the business sector to economic slowdown. I certainly hope that is their concern, because it should be!
Politics & Money: Beltway Bulls and Bears
- One of the sillier narratives floated out there (including by people who intellectually ought to know better) is that in the summer of 2011 the S&P 500 fell 15-20% because of Congress’s fight over the debt ceiling and the S&P reduction of the U.S. credit rating from AAA to AA+. The narrative is told to perpetually scare investors about pending debt ceiling fights, of which we have had about six since 2011, not one of which has remotely phased markets. Now, any future political fight has the potential to disrupt markets, but appealing to summer 2011 is disingenuous and flat out false. U.S. markets rolled over in the summer of 2011 because Europe was melting into the abyss and the contagion fears (and perhaps realities) were deeply problematic. U.S. bond yields dropped during that period (illustrating how serious the actual fear was of a U.S. debt default – which is to say, not at all). This issue is a pet peeve for me. One can forecast a new event for the future without having to distort the past.
- The NAFTA ratification (the so-called USMCA bill) is not completely ready for passage yet, but for whatever reason, U.S. trade officials and other senior Trump administration fellows remain confident that Speaker Pelosi is supportive and will secure Democrat passage. The bill itself ought to generate support from the House (in any other administration), but the politics of it all now are that anything coming from the White House is not likely to get support. The market is focused on China, but we will be watching this NAFTA re-do closely as well.
- Chance of a bipartisan infrastructure bill? Laughable (note the collapse of talks this week between the President and Democratic leadership.
- Chance of a Budget and Debt Ceiling deal? Not any time soon, but I suspect in advance of the deadlines there will be something that allows things to go forward.
Chart of the Week
I believe I may have shared this chart before, though it is more updated now, and I think it is really profound in what it shows. We are indeed living through a very long economic expansion right now (post-crisis), and yet we are also living through one of the weakest on record. And the low magnitude of the recovery perhaps alters the expectation for the length of the recovery …
Source: Strategas Research, Economic Bulletin, May 21, 2019
Quote of the Week
“The truth is incontrovertible. Malice may attack it, ignorance may deride it, but in the end, there it is.”
~ Winston Churchill
* * *
It was a longer Dividend Cafe than normal this week because there was a lot to say, and because I had extra airplane time this week which leads to even more writing. The mornings in New York City afford me an extra couple hours of research time every morning because of the time zone change (I keep my same wake-up time no matter what time zone I am in, which adds a lot to my mornings on the east coast). The fact of the matter is that much of what I wrote about this week is evergreen – and will be true in a year just as it is today.
How do I connect the dots between the behavioral lessons of this week and all that I say about trade, debt, the Fed, and everything else? Because the trade war and industrial production are the things impacting markets today. And in a year it will be something else. And in five years it will be something else still. And through it all, the ability to “follow very good advice” will remain the determinant variable in one’s financial success!
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet