The Dividend Cafe - A Story Better than Tech Stocks

Episode Date: September 4, 2020

In this week’s Dividend Cafe we will address all of this and more: • Market week in review – is this the tech correction we have been anticipating??? • A vast and thrilling ride through the world of zero% interest rates, and what this new monetary regime means for the economy, the future, and oh yeah, all investors! • A tale of two economies • Something to really worry about • The danger of stock splits • The Pro and Con case for the bank sector • Economic Report Card for the Week (special attention to today’s jobs report) • Politics & Money – update on the election betting odds, scenarios for election night, and general volatility expectations • Chart of the Week – a little history of Nasdaq corrections … A perfect way to launch your Labor Day weekend … Let’s jump in, to the Dividend Cafe! 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 this week's Dividend Cafe. For those of you watching on video, I am sitting in the middle of Bryant Park, which is actually just down the street from the first office I ever had in New York City. It is on 42nd Street in between 5th and 6th Avenue. And I walked here this morning and began working because I had more reading and writing to do on my way to the office. And just kind of three or four hours later, here I am. And so I'm going to just record right here because we need to kind of get this done.

I hate recording in the middle of the day when we're in the volatility moments again. It's been a little while since it's been like this. And for a while, we were recording our Friday Dividend Cafe after the market closed. The Dow dropped 800 points yesterday. It's down 500 points today. And both of those numbers actually pale in comparison to the NASDAQ, which is really leading all of this. Most of the Dow damage is kind of incidental,

but it's really being led by a big tech sell-off that is now in just a little over one day reached 10%. And so most of the other sectors of the market are kind of behaving and hanging in there. And keep in mind the market was up quite a bit coming into the last couple of days. So the reason I titled the Dividend Cafe this week a bigger story than tech stocks is because despite the fact that you have these things kind of going on, you really need to be focused, I think, a bigger picture on the subject of Dividend Cafe this week, which is, I think, the paradigmatic changes taking place economically, perhaps culturally, by the way, but certainly from an investor standpoint, which is the reason people come to the dividend cafe, around zero interest rates. And we can talk about the emergency measures. We can talk about what the

Fed should do and shouldn't do. And I do talk about that a lot. There's a lot more to say about that. And I do talk about that a lot. There's a lot more to say about that. But there is a difference in what's going on right now than there has been in some past interventions. And it's become an obsessive study for me and something I'm really determined to get right for my clients. And I don't mean get it right in a one-month or three-month trade. I mean get it right over a 10-year portfolio timeline,

a couple of different market cycles that can and I think will be affected by this to some degree the stock market, but certainly across a broader portfolio, one that is fully asset allocated on a global basis across all asset classes for the purpose of creating a certain risk and reward outcome. And I think a lot of people are excited for zero rates, for borrowers that is, and even equity investors, because there's no question that lower borrowing costs gives a short-term stimulus. And my argument is not that it doesn't. My argument is that it also does other things that we have to be continually looking at.

And I think it's morally and professionally required of me to walk you through these things to, within our investment committee, develop the right response to the situation that's going on. You may just stop at the analysis with, hey, while it helps borrowers and produces a little stimulus there with the lower cost of capital, I recognize that it does hurt savers, and that's a common argument. It's a valid one.

I agree with it. It does, I think unfairly, by the way, inflict challenges for those that are wanting to save in treasury bills, CDs, money markets, more conservative investments, when they're forced into a negative real return, they're forced into a non-return, and then they have to basically adjust income expectations around that, or, of course, go up the risk curve. But it does other things too. And those things are not talked about a lot. They're not talked about enough, and they need to be. The Federal Reserve has used the short-term interest rate and the ability to cut it when you get into problematic times,

when you get into moments of distress, for decades upon decades. And having that buffer of protection taken away is a total game-changer. Now, the short-term rate had gotten up around the 2% level. They were able to cut that down to zero. They were trying to get it up higher. They'd begun cutting it. This credit market's kind of cut off in late 2018, if you recall. So going into 2019, they cut rates a couple times. But here's the thing.

You've averaged going back through the last 10 periods of 20% declines in the stock market, 2.9% worth of cuts to the short-term federal funds interest rate. And even out of the financial crisis, that rate had been around 4%. They were able to cut that more substantially to create that bigger stimulus impact. Well, they couldn't cut 2.9% this time because they were already at 1.5% or 1.75% when they started. But now, next time, they can't cut at all. They're already in zero. And you can say, well, maybe by then they'll have gotten it back higher.

But see, my argument is they won't. My argument is that we're stuck here. My argument is that even by their own dot plots or forecasts, they intend to be here for a very long time, certainly a longer time than we are likely to not have another period of economic distress. What economic distress? Well, do we need a reason? Do we need the exercise of imagination to have the imagination to know that there will be something?

And by something, it could be, you know, this year was a viral pandemic. It could be a housing adjustment. It could be global conditions. It could be geopolitical. I just hope I don't have to make the case that economic distress has come. And losing that buffer is a big deal. But it is not just simply that there's a lost protective benefit as a policy tool that's gone.

And in fact, the Fed does have a plan B around that. I'll get to it in a second. The problem is that there's an offsetting or undermining impact when inflation and real rates get on this side of the equation at the zero bounds. The inflation and real rates rise and fall together in normal times. But when the short-term rate is at zero, that relationship falls apart. This has been the big lesson in Japan. When I say it falls apart, I mean the relationship basically inverts. into Japan. When I say it falls apart, I mean the relationship basically inverts.

That with deflation, when rates are at zero, forces the real rate higher, even as economic conditions are deteriorating, you get a deflationary spiral. Inflation and real rates go in the other direction. So you actually lose any policy impetus whatsoever. And so this generational bond challenge now, bringing it into a portfolio standpoint, becomes a very big issue. Bonds that act like bonds have been an incredible diversifier for 100 years. And when we actually hit the COVID crisis this year, you saw bond prices for U.S. treasuries go up 8%, 9%, 10%. How much did they go up in Japan? Zero. How much do they go up in Europe?

About 2%, maybe 2.5%. Why was that? Japan was already at the zero bound. They couldn't get any benefit in the portfolio from their bond yields. How much did Europe benefit? Europe was not quite where Japan was, but close enough, got very little impact. The United States had some breathing room. It got more.

That breathing room is gone now. And I think that traditionally, as I used Europe, Japan, U.S. as an example, savvy investors that are more globally minded in the past, and I've certainly viewed it this way for many years, at least had a globe to go around to look for yield. One could say, okay, well, things are tight in Germany, but Japan looks more attractive. Things are tight in the U.S., so Germany looks more attractive, or as many, many have done, tight in Japan, so the U.S. looks more attractive,

the so-called carry trades and things like that. so the U.S. looks more attractive, the so-called carry trades and things like that. But what do you do in 81% of all global sovereign debt, 30-year, 30-day, Japan, U.S.? Every bond generated by any country on the planet of any maturity right now, 81% trades below 1% current yield. It's a staggering fact. And therefore leaves investors without the traditional risk mitigation tool and without a source of return.

0% yields means, I want to make this very simple, bonds will provide, that act like bonds. I'm not referring to credit right now. I'm not referring to high yield. I'm not referring to bank loans. I'm not referring to what we call spread product, credit, where there's credit risk. I'm referring to bonds that act like bonds.

They will provide neither return nor risk mitigation going forward. They've provided both for decades. Now, when I talk about there being other options out there, first let's look to what the Fed's other options are. We already know that the Fed learned, and they're happy with the lesson out of the financial crisis, that quantitative easing can be a sort of addendum policy tool to the zero interest rate policy.

So basically, the Fed, I think, will indeed embark upon additional quantitative easing, more aggressive quantitative easing, and perhaps even more creative quantitative easing in terms of the nature of the underlying assets that they're buying or special purpose vehicles, right? As they've done with TALF on now two occasions, a term asset backed liquidity facility. There's creative things they can do to sort of provide additional stimulus when it's needed and be a liquidity provider into the economy.

There's nothing they can do. It doesn't have a cost. There's nothing they can do. It doesn't have some moral hazard. It doesn't have some offsetting risk. But there's things they can do besides just throwing in the towel when zero interest rates lose their efficacy. What do we do in a portfolio? Well, similar for us, we have options. What we don't have is the option to pretend it isn't happening or to just tell ourselves that the return will be higher or that the risk will be lower. has to change or our return or risk, I should say, and or risk assumptions have to change. This is very important. So do I think that most investors want to add to their equity volatility to replace the level of bonds that act like bonds in the portfolio? I don't.

We have to start with the question on an investor-by-investor basis. What is the allocation to bonds that act like bonds that somebody wants in lieu of what the new paradigm will be for their return and their risk level? Ultimately, I believe that the preservation of capital objective can be there. Some very benign assumptions about inflation can be there. And a lot of people won't want to be at 0% of bonds, but they're going to want to be at a lower weighting and not necessarily with the reasoning being

that they are altering their equity allocation or they're afraid to alter their equity allocation. There's going to be risk conversations that take place there, okay? But what I'm getting to is, what do we do with that replacement capital that is inside of a proper return and risk expectation? And I think that a resetting of risk and reward expectations has to take place.

And one cannot simply say that they do not need to have a higher risk tolerance or a lower return expectation in a 0% environment. They're going to have to have one or the other. But the good news with a plan B, just as I think the Fed has more policy tools, is that I think a hardworking or a creative or a determined or a sophisticated investment management team will look for those opportunities that are not creating a free lunch, but are mitigating the risks that the investors are trying to contain and pursue that return opportunity in a different way than they pursued it in the bond market.

It will involve different risks that I, are, are suggested lowest hanging fruit out of this conversation is most certainly going to be alternative investments, but they're not devoid of risk. But the point is to try to not add to the risk you already have layered on in your portfolio. And instead to do so with a real self-awareness

as to what the risks you are and are comfortable that you have and the risks you're comfortable taking to deal with the 0% return environment. This is not a conversation I can do in 15 minutes sitting here at Bryant Park, but it's a conversation that has to happen and that I intend to devote significant resources to in the months ahead. The remainder of Divinity Cafe this week goes into kind of an update on money market fund levels ongoing. I have a chart there kind of just staying in front of where cash levels are in the economy. Pretty heavy amount of conversations in the last couple of days as to whether or not I

think this is the sell-off that I've been waiting for in tech, and it's just too early for me to tell. As hard as it is for me to say, 10% is not very much based on a NASDAQ that was up 70% from its bottom and 30% year to date. I think that some of those valuations were perverse and grotesque and them recalibrating will require more of a sell-off if indeed this is that moment. It may not be, we'll see. It's also hard going into a holiday weekend. You don't really know how much positioning is people not wanting to be naked over the weekend. So, well, you know, Monday with the market being closed,

we're going to have a better understanding next week. The jobs number did come out this morning, and the unemployment rate is, in fact, at 8.4%, much lower than people had anticipated. And there were 1.4 million jobs added in August, including 250,000 in retail. I think it was 175,000 in restaurants and bars. That number could be a lot higher

once more restaurants are open, obviously, but we're headed in the right direction. Just have a lot of work to do still. A lot of work to do. But I also think for you politically-minded folks that there's some stuff in politics and money this week that might be of interest to you around the betting odds, the polling and different scenarios. And as if anyone needs a new risk to think about, I'm getting asked, you know, five times a day, what's going to happen if this happens to the election or what are we going to do if this is the outcome? And I actually throw an entirely different question at you, which has nothing to do with who might win the presidency or who might win the Senate,

but rather something I think is a far bigger likelihood, even though it's a shorter-term scenario. So please read Politics and Money at Dividend Cafe for info on that. Alan Greenspan famously said, to be a success in the predictions business, never write both a number and a date on a single sheet of paper. The implication being a lot of people can predict a number, a lot of people can predict a date, but they can't predict both.

It's very true whether you're talking about interest rates, whether you're talking about elections, whether you're talking about the NASDAQ stock pricing. We're living in some crazy times. I hope that one of the things that will be a little less crazy in the weeks ahead is through this COVID transition. You know, we're used to Labor Day being a kind of rite of passage from summer into fall.

And some schools are starting back up. Some schools aren't. Some conferences say they're going to be playing football here. I'm a college football fan. Some are not, including my beloved Trojans. I don't know. The summer didn't feel normal for a lot of people. The fall isn't going to feel totally normal for a lot of people. And I think most of us are craving some normalcy. So those of you who relate to what I'm saying right now, let's just keep praying for a return to normalcy, a healthy functioning society. And in the meantime,

as it pertains to decisions that have to be made about your investment portfolio, you have to know that we are working day and night to make those decisions in your best interest. We appreciate your trust and confidence. Thank you. Thank you. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions.