Dear Valued Clients and Friends,
I am sending this week’s Dividend Café from the annual SALT Hedge Fund Conference here in Las Vegas, where I have been blown away by some incredible speakers, discussions, and panels over the last couple of days. I am still organizing my thoughts but it has been an enlightening event as always. And of course the news cycle gave us plenty to digest, too. The market finally saw some big downside volatility this week and we have plenty to say about that and the political world and more, so read on.
Is the market afraid of impeachment?
The leaked story on Tuesday that alleged President Trump had exerted some pressure on FBI Director Comey some time before firing him to soften the investigation to former Trump aide, Michael Flynn, caused markets to swoon a bit Wednesday, dropping 370 points on the Dow as the futures market priced in a 33% chance of impeachment (had been 14% the day before). These things are categorically unknowable and to our knowledge un-priceable, but the selling pressure was intense as markets more than anything else hate uncertainty. Let’s ask these questions, though: Were the markets actually assuming that this new allegation would lead to a real action? Were they assuming that some part of the current tax reform conversation was dead on arrival? Were they assuming that a President Mike Pence would be bad for markets? Were they assuming that the Republican majority in the House and Senate was about to change? Was there any real, material, economically coherent sense in all of the uncertainty, rumor, leaks, and allegations of the political circus that stock prices would lose value? The answer is no. And the answer is that Mr. Market doesn’t care about any of the above “stuff.” Mr. Market doesn’t like uncertainty, and for the time being (on Wednesday), the markets were awash in uncertainty, and experienced a long, long overdue down day.
So THIS is what volatility feels like?
No, it isn’t. It usually feels a lot, lot worse. We haven’t seen a 5% pullback since July of last year. This is the longest period without a 5% correction since 1996 – over 21 years. And we still haven’t hit it, by the way. 370 points is a lot to drop in one day, but it skews the reality of what we have been dealing with. Non-existent volatility was not going to last whether all this Trumpian drama took place or not. Normal volatility is, well, normal.
The most mis-understood rally since the last rally
There really is little we can say about the 2017 market action we believe is more important than this: People surprised that the markets had not been correcting as the Trump administration ran into continued public relations debacles, political roadblocks, self-induced challenges (real or perceived), and policy headwinds have essentially all been making the same mistake – They are mis-diagnosing the basis for the post-November market rally to begin with. It actually makes a lot of sense if one believes that all of the market rally since November was purely related to expectations for improvements expected out of the Trumpian economic agenda to now believe markets ought to correct in the context of what has been a very challenging 125 days for the Trump administration. However, the data is abundantly clear to us: This has been an EARNINGS-DRIVEN RALLY. And as earnings go, my friends, so goes the market.
There is some substantive conversation about this very subject here, on my recent Wall Street Week appearance.
Well where does that leave President Trump and this market?
The irony of this all is that ENERGY and FINANCIALS are the two sectors we think will most benefit from the elements of the Trumpian agenda we are quite confident will get through, and those are the two sectors which have most lagged in recent months.
What is so “special” about a special counsel?
The news Wednesday afternoon that the Department of Justice was appointing a special counsel to investigate the Russia/election matter, after all the drama about President Trump’s alleged interference with FBI Director Comey and the big market drop that resulted from such drama, has led to a mixed bag of reactions. No one I have seen has disputed the integrity and reputation of Robert Mueller, the long time FBI director appointed to lead this special counsel. And in a sense this may prove to be the effort needed to bring closure to the whole matter. It also, of course, could create additional uncertainty and open-endedness. We know not how long this investigation will last, nor what it will turn up. And yet we strongly suspect from the vantage point of the markets, it is more likely to create closure, clarity, and certainty, than NOT having the special counsel would.
Oh by the way
Call it coincidence. Call it the GOP accelerating plans based on new political complexity. But all indications are that the Trump administration is planning to release their $1 trillion infrastructure plan within a couple of weeks. Secretary Chao said this week they anticipate $200 billion of public money levered with $800 billion of private capital to create significant spending package around airports, roads, and even broadband.
A bear market for mega mansions in Greenwich, CT?
Despite all the negative press around hedge funds over the last year or so, total assets in the industry increased $70 billion last year (to $3.22 trillion), but investors did withdraw a net net amount of $102 billion (so that must mean investment gains of roughly $172 billion). Over 5,000 institutional investors are allocated in hedge funds. Roughly 1,000 new hedge funds started up last year, and roughly the same number shut down. How will the industry look in the next 3-5 years? We believe there will be LESS funds in existence, managing MORE money, but with more natural investors who sympathize with the portfolio objective of non-correlation (diversifying the source of risk and reward in a portfolio). The real key will be talented managers (because talent matters) finding idiosyncratic investments that meet investor objectives on a net-of-fee basis.
We think of the bio-technology sector as a growth sector – high beta – high volatility – and potential but no assurance, of high returns. Right now, the sector is seeing the lowest valuations it has seen in 25 years. The S&P 500 itself currently has a higher P/E ratio than the biotech sector, and traditionally biotech valuations trade at a significant premium to that of the market. There are a number of reasons for this, and admittedly it is somewhat problematic to base the sector valuation on a blend of all companies when there is such a huge divergence of circumstances across companies in the sector. With that said, we wonder if biotech could become a value sector in due time. Before you laugh, we didn’t used to think it could happen to software, routers, or microchips either!
An emerging acknowledgement
We are devoutly committed to the idea that real long-term emerging markets growth investing should not be dependent on currency strength (or put differently, dollar weakness), and we are quite confident our approach does not serve as a high beta currency play. With that said, we certainly see that the dollar rally of November coincided with EM weakness, and the dollar sell-off of 2017 has been a catalyst to the short term strength seen thus far this year. The chart below shows the dollar over the last year.
Hate to interrupt this political drama with Fed drama, but …
The story of the Fed raising rates a couple more times this year has quickly become a backseat story to that of their “balance sheet run off” plans. In other words, the Fed plans to exercise a very modest form of tightening by slowing down their reinvestment of securities on their balance sheet when they mature. This results in less Fed activity in the market, which is a fancy way of saying they are allowing the long end of the yield curve to potentially come in. It reduces the bonds on the Fed balance sheet (perhaps even modestly reducing money supply). Our best guess is that the Fed continues to reinvest treasuries as they mature, but will cease reinvesting Mortgage-Backed Securities, or at least slow them down. We also guess they wait until early 2018 on this. The specific details are going to matter, and they also will make your eyes gloss over. We are going to be watching carefully.
Chart of the Week
This is the story of the market rally. Earnings growth reversed in late 2015 and early 2016 and we know what happened to markets. It is the resurgence of earnings growth that has driven this market.
* Strategas Research, May 15, 2017
Quote of the Week
“On what principle is it, that when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?”
– Thomas Babington Macaulay, 1830
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I am sending this week’s Dividend Café from SALT, the annual hedge fund symposium here in Las Vegas I attend every year. This year’s event was as deep and rich as they always have been, and I do share some key takeaways at our www.marketepicurean.com site if interested. But the one theme that is still so evident across the major players of capital finance is – “what next?” From the political to the monetary to the economic – everyone simply wonders what the next inning or phase or cycle will be. There are arguments for correction, and arguments for substantial reflation rally. But very few expect “doldrums” to last forever.
Our position is that something will be happening “next,” because something always happens next. And what that is going to be will something that in no way negates the laws of investing, that investors accumulating capital need to generate compounding in their portfolios, and investors withdrawing income need to generate cash flow. Doing this through high quality investments whose temporal valuations from one day to the next will never be fixed in time, but whose cash flows internally and externally are growing, even as their underlying business model is stable and secure, we believe represents the single best plan for what is “next.”
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Partner
Brian T. Szytel, CFP®, AIF®
Managing Director – Private Wealth Advisor Group, Partner
Kimberlee Davis, J.D., CDFA®
Managing Director – Financial Planning, Partner