The Dividend Cafe - A Gold Medal for Disciplined Investing - August 5, 2016

Episode Date: August 4, 2016

A Gold Medal for Disciplined Investing - August 5, 2016 by The Bahnsen Group

Dear valued clients and friends, welcome to the Dividend Cafe podcast. Today is August the 5th, and there's a number of things we want to go through entering the month of August. We've enjoyed a great year so far in our equity and fixed income results both, but mixed results across alternatives, a lot of unknown certainly exist in the big picture, macro affairs economically and so forth. No honest and appropriately humble portfolio manager should fail to recognize that there is risk in both directions for markets right now. If one reduces equity exposure in a meaningful way and then better economic news and anticipated comes or global affairs turn unexpectedly, stock markets could rally really hard. And that can be just as frustrating as when one

increases equity exposure and then a sell-off ensues. Risks feel heavier on the downside though, and we also have to constantly remind clients how dangerous it can be to obsess over weekly or monthly movements. We'll discuss all of this and more this week, so let's get into it. In terms of the executive summary of this week's message, point one would just be that oil had resumed a downward trend, breaking modestly below $40 earlier in the week, reigniting concerns about global strength. Equities had not been participating in this downward move, actually going the other way through most of July. But stocks did see a lengthy losing streak recently, even though that was broken up on Wednesday of this week. And then now even oil has rallied

quite a bit on Wednesday and Thursday. But even that stock turn down was mostly a combination of very light down days. And that was probably correlated with the drop in oil to some degree, but so far, besides some weakness in energy stocks, it really hasn't caught up with industrials and materials sector like it did earlier in the year. Number two, investors deserve an absolute result, an investment strategy tailored to them achieving their goals, not a random, arbitrary, and frankly, irrelevant focus on how they did relative to the stock market. Investors have different goals, different risk profiles, different timelines, and therefore, different asset allocations. To try and benchmark all clients to the S&P 500 or the Dow or something like that. It's not just

unhelpful, it's dishonest. We're going to talk about this a little more in a moment. And then number three, the economy may go into recession next year. It may not. Stocks may go down next year. They may not. I would imagine they would to some degree if we'd enter a mild recession. Portfolio decisions need to be made around liquidity needs, liquidity protection, and of course, valuations. The income a portfolio generates needs to be growing, whether its value is growing or not, in a given period. Short-term excessive timing decisions are not only a gift to the taxman, they're utterly futile for one's investment return. In the news this week, there's obviously a lot of disarray in the Trump campaign. The Hillary Clinton lead in the polls is now quite significant. The Bank of England cut their federal funds rate, their overnight lending rate, by a quarter of a point as expected, which was their first interest rate cut since March of 2009. And then we are going to press.

I'm kind of doing this podcast before the jobs report has come out Friday morning, but you're listening to it after the jobs report has come out. So we'll have to cover the implications of what the jobs report said in next week's Dividend Cafe. So as we said, oil broke below 40 and was showing a sort of technical deterioration. There is talk of extra production in Iran, Iraq, and Libya being a factor. The dollar is sort of all over the map. And so what the dollar is doing in relation to different currencies should end up kind of recalibrating things. But this reversal back up in oil Wednesday, Thursday could mean that a formation of a bottom is in place because it's been quite a sell off here over the last month. In terms of the recession watch, Q2 real GDP growth number came in late last week at a 1.2% analyzed level. Really only the consumer was holding things together.

Fixed investment, inventories, and government spending all subtracted from the economy in Q2. all subtracted from the economy in Q2. The bottom line is that to get to about 2.5% real GDP growth, let alone even 2%, means that the economy does not have the cushion to withstand the negative drag of a global slowdown in the next 12 or 18 months. CEO confidence and fixed investment are the two areas that we think would have to move to feel better about the economy and the possibility of a recession aversion. We provided some charts to that effect in DividendCafe.com this week. As far as earnings go, it's interesting that for all the logical concern about earnings growth deceleration, the slowdown in the growth of earnings, there's been almost no talk about top-line revenues that have actually grown year over year. This is in Q2. This is the first time

this has happened in two years on a quarterly basis. So where we stand now, 71% of companies have beaten in earnings results, and 55% have beaten their expectation for top line revenue. And as far as the election, we already commented it has not been a good week for the Trump campaign. I'll leave it there. We had some great questions from readers and one I already alluded to in the executive summary, but I want to elaborate a bit here. The question was, could you include market indices in your Dividend Cafe commentary that compares what your portfolios have done to the market over three, five, and 10-year windows, and also would kind of track quarter by quarter? My answer is no,

we could not, and we would not, but it would be good to explain why number one we only manage money on a custom discretionary basis how could we compare our portfolio to a market index when various clients have dozens of combinations of portfolio compositions number two what market index would we use some clients have emerging markets. Some do not. Some have 30% in stock. Some have 70%.

Some use taxable bonds. Some use tax-free. The S&P 500 is a vanilla 100% U.S. equity index. So it doesn't work unless we want to compare apples to oranges. A custom benchmark could be created for each client, but the allocation of that client changes over time. And the custom benchmark for one client surely wouldn't apply to another. And then there's number three, by far the most important reason. And that's that if we did such a thing, we'd basically be implying something that is utterly false.

And that is that comparing one's portfolio to a market index has any benefit, any meaning, any utility whatsoever. It's the height of dishonesty to even play into the farce that such a thing means anything to our clients, let alone to us. We manage money to see the cash flow our portfolios create grow year over year, either for someone withdrawing it or someone reinvesting it. If in a given year our raindrop is moving faster than the S&P 500 down a window, it doesn't cause us to celebrate. And if in another year the market is outpacing our raindrop. It certainly doesn't cause us distress. Our clients hire us to create a certain result in line with their goals and needs and to do so within their comfort level of volatility. That's our benchmark. That's our index. No one, I mean

no one has a goal of beating the S&P 500. I ask people all the time, if you had been up 1% per year from 2000 to 2009, 1% per year over a 10-year period, would you have been happy? And they always say, of course not. But the S&P was totally flat in that period. So 1% would have outperformed. Would someone have cared that they beat the market by 8% in 2008 if they were down over 30%? Because that's what would have happened. Our index is to create a superior flow of income and a superior growth of that income. And in doing so, create a consistent return with much less volatility. That's what we do.

That's what we're exclusively focused on. Question two was, is the driver for emerging markets now just the expectation that weaker monetary policy will continue in the United States and basically weaker monetary policy elsewhere, which keeps the dollar down and emerging markets up? And we are optimistic about emerging markets bonds right now. And we do think a lot of that appeal is related to people searching for yield. The low rate environment elsewhere means they can't get it there. But really, we don't invest in a short-lived, monetary-driven rally when it comes to emerging market stocks. Rather, we want to be invested in operating companies with real earnings, real earnings power, and a real long-term growth

story that transcends the extremely transitory nature of things like currency movements. So for us, we do respect that the monetary policy happenings around the globe will create short-term impact on our emerging markets investments in both directions. But our desire is to be invested in emerging markets that have long-term fundamental attraction. Our final question was, if you believe stocks will drop 50% next year, should we go to cash because we may need income from our funds in the next few years? next year? Should we go to cash because we may need income from our funds in the next few years? I want to clarify, I think there's a 40 to 50 percent chance of a recession next year. I don't think there's a 40 to 50 percent drop in stocks coming. As one who's getting closer to needing funds from their portfolio, it's the job of the financial advisor to plan liquidity needs well enough that liquidity,

cash, is always there when one needs it. As one who will need funds with cash and bonds paying close to 0%, the reality is cash and bonds could become a bigger risk to your goals. Market timing is a fool's errand. It doesn't work. We manage the risk. We watch valuations and make tactical decisions. And above all else, we have to intelligently plan for clients' liquidity needs.

If you do go to Dividend Cafe, there is another question this week about the state of MLPs and another question about U.S. growth and the overall global economy. Another question about U.S. growth and the overall global economy. In terms of our weekly reinforcement of a permanent principle, these very simple words, risk is the possibility of permanently losing money. Volatility is just the expected fluctuation in value as we advance towards our goals. The bull in us this week does like emerging markets bonds, at least for a bit. They've had a heck of a run, and we're really happy with our decision there.

And the bear in us this week, we have a chart at Dividend Cafe, really down on the auto sector right now. Auto sales have lost momentum, and we think we're finally seeing what we had forecasted sometime back come to fruition, which is that a lot of the robust sales of the last couple of years were future sales that were brought into the present by financing incentives and things like that. So with all that said, we'll go ahead and leave it there for the week. The run in markets post-Brexit, particularly in the types of bond sectors we're invested in, and then also the dividend-rich,

low-volatility spaces we tend to like, it's been extraordinary. The prolonged period of everything going well is actually never something we want to see, even though we do know clients like it. But it creates the inescapable feeling for us of, okay, what's about to happen now? Markets are looking for various ways to normalize. Volatility has been very low the last few weeks, and it hasn't turned into a calm before the storm moment. But people are asking what we plan to do next. And the truth is sometimes the best next step is to do nothing for a little while. We have client allocations well balanced.

We have a small tilt towards the more conservative side. And most of all, we believe our clients are well placed into the wisdom of the notion that short-term movements are unpredictable. that short-term movements are unpredictable. We think clients have bought into that, and we have worked very hard to explain that these short-term movements are completely irrelevant to your long-term result. We are playing more defense than offense right now. We're very engaged in the macro picture. But if you just start throwing in more seasoning for the sake of doing such

and keep stirring the pot for no real fundamental reason, you risk messing up what's a pretty good dish. So we like our portfolio process right now. We think it is very elegant in its allocation, but it's simple enough, not excessive. We have a lot of intentionality in what we're doing and we don't want to be stubborn about the decisions we make. So to that end, we continue to work. Please enjoy the opening weekend of the Olympics. Thank you so much. Reach out to us with questions anytime.