Dear Valued Clients and Friends,
Markets are up this week again as earnings season moves further towards completion, and continued statements around tariffs and retaliatory tariffs are met with continued apathy by the market. I’d like to think this week’s visit in the Dividend Café addresses the big issues around the market right now – from the basis for market optimism to the prospects for more capital expenditures, to the real debate behind inflation and deflation. The Politics & Money section is a must-read, especially for those wondering about the mid-term elections. And frankly, there are a few charts that I believe to be among the most illuminating charts we have ever published. So come on into the Dividend Café and let’s get more informed together.
Dividend Café Video
Dividend Café Podcast
Revisiting general optimism
Believe me, turning bearish on markets, and becoming a broad-based pessimist on the outlook for the economy and risk assets, is not something I am afraid to do. The fact of the matter is that the investing public loves listening to market bears and that the mere novelty and blow-hard profundity of many perma-bears always finds an adoring audience. It’s not in my DNA to alter my views on investment allocation or market prognostication to “find an audience.” There are evergreen principles we believe that find a frequent voice in this weekly commentary, and there is the weekly perspective I offer requiring the objective calling of balls and strikes. And in fact, we have been modestly positioned towards a more equity-defensive allocation (not extremely defensive, but modestly so), for quite some time. If I believed the catalyst was finally here for a substantive alteration of equity market values, I would not hesitate to say so.
That said, earnings-per-share growth remains phenomenal (+23.5%), and tax cuts can not and do not explain all of that. Revenue growth (top line) remains quite strong (+9.2% year-over-year growth). The concern of rising bond yields has not proven to be a very legitimate concern, as empirically equities have responded to the positive in seven out of the last seven periods of rising rates. And thus far, even the trade war issue (which I loathe, and earnestly disagree with the administration on), has still resulted in very low actual tariffs relative to past trade/tariff flare-ups. I am happy to advocate for caution in the high-valuation growth sectors of the market, but as for broad market health, especially in the more “value” oriented arenas (more on this below), my objective call is that earnings growth and economic expansion justify an optimistic market outlook
Capex or bust
There is no more coherent argument for a continuation of the bull market than the argument that capital expenditures are on the rise, and in their continuation, a further run of productivity growth is coming that is expansionary, healthy, and opportunistic. Of course, the thesis starts with the premise that capex is, indeed, on the rise. Our thesis has been and continues to be, that the corporate tax reform has created the economic backdrop for such capex, and that a follow through on this business investment will be the fodder for the next expansion. The chart here speaks for itself – a sustained movement in this direction is definitionally bullish.
Deflation vs. Inflation
As the chart below indicates, what some are calling a “fear of inflation” is, thus far, barely a half-retrenchment towards the median bandwidth we have been in for nearly 20 years. The sharp drop in price inflation from the classic deflationary conditions of the financial crisis has not even been replaced (yet). The reality remains that “re-pricing” of risk assets around the risk-free rate (a fed funds rate at 2% vs. 0%, for example, or a 10-year at 3% vs. 2.5%) is categorically different than adjusting for secular inflationary conditions.
Deciphering “Growth” and “Value”
I have the difficult balance to strike of not repeating myself ad nauseum on certain topics, and also not assuming all readers have read or understood a given viewpoint. Our discomfort with the distinction between “growth” and “value” is a topic I have discussed many times, but do not want to take for granted. The nutshell is that we get what people mean when they use the terms, but also find them unhelpful, in that a “value” company which had no growth prospects sounds like a bad investment to us, and a “growth” company we had to over-pay for also sounds unattractive. By definition, no investment should (or would) ever be made if the buyer did not feel there was “value,” and there would be no value without the belief of some renewed or accelerated or sustained “growth.”
With that said, the “indexes” of these respective “styles” point to varying relative results (the chart below is not how growth and how value did, but rather how growth divided by the whole S&P 500 did, and how value divided by the S&P 500 did). And one style has generally outperformed the other at various points and for various eras. Now, this chart only goes back to 2010. The prior ten years look very, very different. But my point is this, the outperformance of growth vs. value, with varying zigs and zags along the way, is as over-cooked as any fact in investing.
* Russell 1000 Value & Growth indices, 2018
The year our lives changed, the country changed, the world changed
Solving the trade deficit problem
I am hoping you caught the use of the word “problem” in this sub-title, for hopefully those of you more diligent readers know that I do not remotely see trade deficits as a “problem” (in and of themselves). Inversely, I do not see trade surpluses as a good thing, necessarily (neither does Venezuela). But to the extent one may be looking to see a trade deficit shrink (I think it is fair to say this President is looking for such), there is no lower hanging fruit for doing so than exporting energy, particularly to China. If China becomes a big net buyer of U.S. food and agriculture, giving the President the political victory he wants of a declining trade deficit, and given China the benefit of our energy and food, there not only exists a path to ending this trade/tariff debate (besides the issue of intellectual property theft), but also to a truly investible thesis.
Volatility vs. Relevance
The chart here shows the movement of the S&P 500 over the last year (both equal weighted, and market cap weighted). You see the big move up that was the end of 2017 and January 2018, then you see the big drop in February, and then, you see what has been the story of 2018 – up and down movements within a few percentage point range – textbook choppy volatility. Finally, you see the last month, where new highs since February are being set, and we are quite close to re-testing January highs. Jumping back in now after being on the sideline throughout this fun has cost people 5-10% of return. Market timing is a fool’s errand. I repeat: Market timing is a fool’s errand.
Maximizing returns or minimizing regrets
I have written in the past about the powerfully destructive force of regret in the life of an investor. It generally goes something like this – an investor gets spooked out of the market during a difficult time, the market recovers thereafter, the investor regrets his or her panic exit, and in the emotional throes of such a dilemma, the regret causes one to “wait for a dip,” often building up more and more regret for the exit, and now the waiting, causing a crescendo point where the investor jumps back in, just in time for a correction, leading to more regret, rinse and repeat. The regret dynamic in investing is unavoidable when one’s ill-advised behavior puts them on the regret cycle. It is merely the human reality and manifestation of the great evil of market timing. And we exist to minimize such regret … to that end, we work.
Politics & Money: Beltway Bulls and Bears
- China announced a new round of retaliatory tariffs (25% on $16 billion of imports) – in response to the U.S. having announced the same. The markets did not move. The products include 250 items, largely in the electronic circuits, motors, farm equipment, tractors, and motorcycles space.
- The potential to adjust capital gain tax liability for inflation continues to have momentum within the President’s economic team. The policy is sensible from my perspective, but one issue of impact lingers … If this is implemented, would the implementation be effective immediately even in the face of inevitable litigation from those claiming the Treasury Department lacks the legal authority to do such? I am quite confident such a lawsuit will come, though reasonably confident Treasury would prevail. What is too early to say is whether or not implementation could begin through the headwinds of such litigation.
- I should note – with an H/T my friends at Strategas Research for making this point – individual states with high tax rates would also be big beneficiaries of this policy (which are, ironically, almost all blue states). The inflation adjustment at the federal level wouldn’t matter to states, and yet presumably a significant amount of capital gain realization would take place as a result of this federal policy change. States would, therefore, receive tax revenue they wouldn’t otherwise have received. So indirect winners (this point is mine and mine alone)? Municipal bond investors in high tax states.
- Are markets likely to be impacted by the results of the midterm elections? We think not. Is the House likely to swing to Democrat control? At this point, yes. Is the Senate likely to stay under Republican control? Very likely, yes. Are these outcomes essentially expected in markets now? Pretty much. But beyond any of the political projections, the fact of the matter is that very little of market implication is expected under any result of this midterm.
Chart of the Week
Those who begrudge the level of debt in society (and I am very purposely talking about private debt, not the insane levels of government debt), would be wise to understand the actual leverage rates we have post-financial crisis. Even as individual debt levels seem higher, they do so with a substantial increase in the value of the underlying assets collateralizing said debt, meaning, the leverage level has been collapsing. Net worth is up 50% since the crisis, while liabilities are up just 6%.
We can, and should, bemoan the way leverage (debt divided by assets) has moved in the public (governmental) sector, but the facts show individuals and households going in a very different direction.
Quote of the Week
“Investment success accrues not so much to the brilliant as to the disciplined.”
~ William Bernstein
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It will be interesting to see how markets hold up at the next bout of volatility. 2018 has seen an explosion of volatility, relative to 2017’s historically low volatility, but it has not been all that abnormal from a historical standpoint. Remember, market volatility is the norm, not the exception. That said, recent weeks have seen a real calming in market volatility, and that often lures in unsuspecting investors who are not investing with the right foundation in place (meaning, with the awareness that volatility is good and normal, and part of the trade-off for their long-term superior return). So all that to say, things are calm now. Unless you work in The Bahnsen Group’s offices.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group