The Dividend Cafe - A Booze Free Punch Bowl

Episode Date: May 6, 2022

Market volatility is on a roll, with the VIX now double the level it started the year at. This week saw the biggest up day we have had all year, followed the very next day by the biggest down day of the year. A lot is happening, and we can and will unpack it in today’s Dividend Cafe, but we will not leave it there. The takeaway today will be what to do about it (or not do about it), and that is why you should enter the Dividend Cafe. Knowledge followed by action. To that end we work. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another week of the Dividend Cafe and welcome to another week of some pretty insane times in the market. And I normally do not, actually, I regularly do not consider volatility to be insane. I don't consider a good week insane. I don't consider a bad week insane. But when you do have the biggest up day of the year and the biggest down day of the year, right next to each other, as we saw Wednesday, Thursday this week, that's pretty abnormal. Thursday this week. That's pretty abnormal. And so again, I think that some thoughts are in order today in the Dividend Cafe on the reality of market volatility, the particulars of this market volatility, what it does not mean, what it does mean, and what the key takeaways out of all of it are. So I'm kind of pumped up on this subject. Unfortunately, I'm having to record at my house here in Newport Beach on a Friday morning because I'm on my way

to a day of team meetings and other things that are going on with our leaders at our business. And so I'm not in the studio this morning, but I do hope that the backdrop of where I'm recording means nothing to you and that the things that I'm saying hopefully mean at least a little something. What I want to start with is a high level understanding of the present volatility. The notion that there are economic uncertainties, you know, what is manufacturing going to do? We got to look at the labor data, the jobs up, jobs down, GDP growth this quarter, last quarter, next quarter. Those things are creating an elevated level of uncertainty. The Russian war in Ukraine, the various geopolitical things, all of it is both true and untrue at once.

What I mean by true is, yep, all those things are pretty uncertain. All those things are up there. We're all looking at the data. This week, the PMI, and next week, this and that, wages. Okay, that's all true, and there's varying degrees of uncertainty in a lot of those things. Russia was not at war with Ukraine last year, and they are this year. But last year, there were other geopolitical things, and I've made this point before. But last year, there were other geopolitical things. And I've made this point before. oh, yeah, there's this economic data.

I'm going to go wrongly predict it and then wrongly execute on what to do about it. Because you're not going to be right predicting it and you're not going to be right executing on it. And that's a permanent condition that applies to myself. And it's a permanent condition that applies to the great portfolio management talent of the universe. that applies to the great portfolio management talent of the universe. So what is relevant or particular in the current volatility environment is more Fed-oriented. There is a more Fed-centric dynamic after a long period of excessive Federal reserve accommodation. There is enhanced uncertainty or volatility around what the Fed now is embarking upon doing. And there's two dimensions to that. One is the just general uncertainty. How far will they go? Where will rates be? What's the

impact going to be? Will interest rates get to a point it causes a recession? How does it impact valuations of risk assets? Does it impact valuation of risk assets? Yes, it does. And I've talked about this and written about this in the past a lot. But then what's the magnitude of the impact of valuations? I don't think anybody knows that. And so there's uncertainty that is higher when the Fed is directionally tightening versus directionally loosening. And even though you could hardly call a 0.75% Fed funds rate with a $9 trillion balance sheet tight, it is getting tighter because it's gone from zero to 75 basis points, and it's going to go higher. And so that tight versus tighter is an important distinction, because we're not in tight monetary policy, but we are going tighter, and direction matters to

volatility. When directionally, you know, they're loosening and loosening. That's where markets experience greater ease. And in fact, expansion of multiple expansion evaluation, prices going higher and everybody celebrating together. So that uncertainty dimension out of Fed, but then the concern about the Fed removing something that markets or investors or risk asset holders want. What is that thing they could be removing? It's a sort of protection, a backstop. So I did a lot in DividendCafe.com today to play out the theme about a punch bowl.

We hear it all the time. I think Greenspan started this analogy. I don't recall exactly, but it's fair enough when people talk about that the Fed has to kind of pull away the punch bowl, meaning markets are liking a lot of accommodative policy, but then they remove the punch bowl as people are getting a little too liquored up and all of a sudden it brings things down. There is a thing about this analogy that's always bothered me is that first of all it really does infer that the hangover is the bad part and the drunken silliness is the good part and i do know

what people mean by it and i'm not an idiot but i don't think that people paying too much for asset prices is a good thing and i don't think analogously that the person who starts getting too loud and obnoxious and boisterous at a party was ever all that really pleasant either. And having to send someone home to sleep it off, you know, the fact of the matter is that if we're going to use the punch bowl analogy, it is not merely removing the punch bowl that was problematic, but the punch bowl itself. And I think that having excesses and risk assets are not just a problem when they have to come down. They're a problem in and of themselves. They misallocate resources. They draw in capital that can be more efficiently deployed elsewhere. And they create a boom-bust cycle.

They do not defy laws of nature. At some point, gravity takes hold and other economic and mathematical and logical laws kick in. And so the fact of the matter is, I don't really think we should always be talking about the hangover. You want people sleeping it off. You want people sobering up and not acting obnoxiously. But this portrayal as if the boom part is good, the bust part is bad, I disagree with fundamentally. I hope you see my point. But all that to say, I would argue it this way. Is the Fed going to remove themselves as a backstop from the really bad things that could happen? The generational credit crises, the once a century pandemic, those moments in which a lender of last resort is supposed to be there. I don't believe they're

going to, but I think that the fact of the matter is they're more equipped to be there. I don't believe they're going to, but I think that the fact of matter is they're more equipped to be there and actually be empowered to play that role if they do in fact go about the path they're going on now, normalizing to some degree. And so while you have to accept the uncertainty and the various repricings that come with normalization. The fear that it actually goes further than normalization into a more dramatic role of the Fed has removed not just the punch bowl, but removed their role as backstop, lender of last resort, emergency liquidity provider, I fundamentally disagree with. In fact, I think they're enhancing their role and they're putting bullets back in their gun if we believe that's supposed to be a function that the

Fed will have. But then let's move it now into a bit more granular of a sense, not just why we have volatility, not just what fears of uncertainty are, but when you really dig into the economic concerns of where we are, the return on invested capital versus the cost of capital being that sort of spread that matters to a recession and that we can look at some of the things the Fed's doing or other impacts from inflation, wage prices, productivity, to look at that return on invested capital, there's two inputs there, there's two numbers we're looking at. And the fear is that they will let that ratio invert for a prolonged period, that you will have a long period where the return on invested capital is less than the return, the cost of capital. And that is a recession, creates a recession and that you let that last a while and that that becomes this sort of deflationary exercise to rid the world of inflationary excesses.

Well, I can't sit here and tell you it won't happen. Right now, the 10 year is 2.25% higher than the Fed funds rate. And when Volcker was doing his thing, the Fed funds rate was 1,000 basis points higher than the 10-year, 10%. So do I believe that we're looking at Volcker-like draconian action? I most certainly do not. Not even close. But could they? I mean, is there some Volcarian instinct that's about to come out of these central bankers that have all spent 50 years being told that the greatest, the worst fear of all time is deflationary debt cycles. I think it's pretty unlikely. How far do they let it go?

Does the Fed funds rate get up to the level of the 10-year? I doubt it, but that could happen. We talked about recessions last week, what it would mean, what it doesn't mean. But I would simply say that those worried about that level of outlier event probably fail to understand the key difference, which is the entire culture has now decided politically that it's revol a good thing for wealth effect. The whole culture has sort of decided that the government should spend 130% of, carry 130% of debt relative to GDP. You know, previously we were in a number that was about one fourth of that. And so the ability of governments to finance their own debt, the ability of corporate America, which we now do sort of take for granted that it's a reflationary capacity is a given for economic growth. We want corporate America to be constantly reflating, borrowing, spending, investing, growing, producing as a means of ongoing economic growth.

reducing as a means of ongoing economic growth. And when you have that sort of significant delta between cost of capital, return on invested capital, all that leaves the room. I think that we are just nowhere near that kind of environment. Mathematically, we know we're not, but I think the likelihood of it even coming close to coming close to getting there is very, very low. But it doesn't need to be there for there to be damage to markets, compression in multiples, compression in valuations, volatility like we're experiencing now. And all of it speaks to a few takeaways. You want to favor quality over not quality. You want to favor value over growth in this dynamic if you're concerned about compressing valuations. But see, I kind of believe that anyways, even if we're not in an environment like this. It just happens to be more enhanced right now. Dividend growth provides

superior income and superior growth of income, which is both counterinflationary and it is more defensive as asset prices hold up better in that environment. You want to favor good credit quality. Now, ironically, on the bond side, if anything, we're getting to a point where we may want to put a little more risk in the credit portfolio because we're starting to get paid more for it. And yet we have a very high quality bias in our equity portfolio. So it affords us the luxury of maybe putting a little risk into the credit portfolio. We're not quite there yet, but our investment committee is talking about some of that. So my point is that what you do is probably what we would recommend

you do anyways, which is favor quality and dividend growth. But then what you don't do is believe you can time your way in and out of it. You don't believe that long-term goals that are met with long-term assets are supposed to react to short-term dips. What you don't do is blow up a good asset allocation and to instead rely on your ability to time your way out and time your way back in. And that to me is the behavioral takeaway that we have to conclude with. So yes, from investment standpoint, we have things we want to do and not do in this environment we're doing. And I think they're working very well for our clients. But I think behaviorally is a far more

important point is those who say I want to time this, even if they have a portfolio I don't like, I really wouldn't do that. Now, I always believe it's the right time to get a portfolio that's suboptimal to become optimal around quality, around diversification, around asset allocation. But the mere timing for the sake of guessing what the Fed's going to do or what the economy is going to do or what macro data is going to look like, I think is absurd. So there's a chart of the week. There's a couple of charts in the middle of dividendcafe.com that are great takeaways of what I want you to get out of this Dividend Cafe. I am off to my meetings for the day, but I really do want to say that this is a very important time to reinforce and reaffirm these principles around volatility, around the reality of uncertainty, around volatility, around the reality of uncertainty, around market forces, what to do,

not to, and come away with a renewed love for quality, for principle-based investing, and for not violating your principles when you get enhanced volatility. That's the key. There are a lot of people who manage investment capital for a living who have no principles. And there are a lot of people who claim to have principles that have no stomach to stick by them during difficult times. Principles were made for difficult times. You do not dismiss principles in bad times. You stand firm in them. To that end, we work. Thank you for listening to and watching the Dividend Cafe. Look forward to coming back to you next week. I think next week I'll be recording for the first time from our Nashville, Tennessee office where I'll be working all of next week. Thanks again for listening to Dividend Cafe.

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