The Dividend Cafe - A Win Streak for the Ages and Company Profits Galore – July 22, 2016

Episode Date: July 22, 2016

A Win Streak for the Ages and Company Profits Galore – July 22, 2016 by The Bahnsen Group

Welcome to this week's Dividend Cafe podcast. Dear valued clients and friends, when earnings season becomes more enjoyable to watch than your own political party's convention event, you know either that the stock market is doing well or your priorities have probably been improved. It has been a crazy week, but not because many of our stock holdings have released disappointing Q2 results. It's actually quite the contrary, but rather for so many other reasons from Cleveland to elsewhere. As of Friday morning, the markets are modestly up on the week, but that doesn't quite tell the whole story. There's some big winners and big losers already

out of earnings season, but we're going to get into it. There's some big winners and big losers already out of earnings season. But we're going to get into it. There are a lot of great foundational charts that we think are really helpful to understanding a lot of what we're talking about posted at DividendCafe.com. So beyond the podcast, feel free to look at the actual web posting if you want to see some of these charts. To quickly summarize a few points that we're going to make this week, number one, through Thursday evening, the market was basically flat. It's modestly up here Friday morning. Number two, if oil prices are heading south again, because they have come from about $50 down to $44 and sort of held there in the last couple of

weeks. But if they are heading that way, and perhaps even lower, I guess the big question we'd ask is why are high yield bond prices that are linked to oil companies not saying so? This relationship between credit and oil is very important to watch. Earnings season is looking quite strong so far, but we do want to emphasize so far. The worst performing asset class in the last few months, at least right up there as the worst, is cash. Investors playing market timing games have missed out on tremendous returns in almost all risk assets. And even worse, it forces them into making a second bad timing decision or potentially bad timing decision as well. Finally, MLPs have not seen the prices. Investors will pay for their yields, relatively speaking, due to the same factors that we've talked about for quite some time.

That is fear out of what took place last year. They haven't moved the same way REITs and utilities have, although they're certainly well off their bottom. In the news this week, the Republicans completed their convention in Cleveland with the expected nomination of Donald Trump. It would be hard to exhaustively commentate on all that's transpired this week in Cleveland in this space, but let's just say it was an interesting convention. Mario Draghi this week announced that the European Central Bank was doing nothing new for now, but presented a handful of strong hints about being ready and willing to act further, which is to say further lower yields, negative, purchase more bonds, and generally weaken the euro currency where they can so to effectuate their monetary weaponry.

In our core this week, China oil recession and earnings. China, the 6.7 real GDP growth rate for Q2 was impressive. It was 8.4% nominally, 6.7 net of inflation. But so much was from the housing boom and construction activity. As those numbers decline into the future, there likely will be an acceleration to this slowdown of growth. Private sector investment has continued to slow. Their tradeoff between avoiding a bubble and maintaining growth targets is a wacky needle to thread. So far, waters are

still, but again, so far. In terms of oil, with prices having dropped about 10% from the $50 range to $44, $45 range, it's fair to question if oil prices are getting ready to roll over again. But as we said in our summary, one noteworthy argument against such is how differently high-yield energy credits are acting this time around. Whereas last time the collapse in oil prices seemed to come with a flood of bond defaults or at least distress in the high-yield sector. This time, credit markets appear to be saying we're not that worried about oil prices dropping much further. These things are really, really in flux, but there's a great chart to this effect at DividendCafe.com.

From a recession standpoint, we are firmly in the camp and have been for a really long time that the U.S. is in what's called a muddle-through economy, which is to say not recessionary, but not in an impressive growth mode. Tepid, lackluster, cool, but net positive. So by definition, not recessionary. The manufacturing outlook is moderate. Consumer behavior is flat. Housing starts are solid. Unemployment's low, but wage growth is anemic. It's a mixed bag. In terms of earnings results, around 20% of companies have reported results so far. Earnings season can be credited with extending the rally in the sense that 70% of companies have beat their earnings expectation.

But actually, more impressively is that 57% have beaten on top line in terms of revenues and sales. That number was far lower last quarter. Plenty of results to come though. A reader asked this week, we know you're raising a little bit of cash here and there just as dry powder in your client portfolios, would you consider taking a meaningfully high cash position ever? 30, 40 percent? It is noteworthy that in the big post-Brexit rally that ensued, U.S. stocks made all-time highs, the Japanese Nikkei went up 10 percent, bond prices rallied really hard, and gold even rallied as well. In other words, the only place to have not made money the last few weeks was in cash. And this speaks to the reality of market timing.

Going into the next phase of market action where there is a lot of global uncertainty, negative bond yields, challenges for hedge funds, and frothy stock valuations, the reality is that cash simply guarantees a 0% return and a negative one with inflation. It exposes people with excessively high cash positions to the atrocious dilemma of when to come back into risk assets, which rallied while they were out. It's a terrible position to be in, and keeping cash positions light and merely tactical is the best way to avoid it. Another reader asked, what do you think of the Shiller PE as a way to measure stock valuations? Professor Shiller says average earnings over full cycles serve as a better metric because of corporate profit volatility. because of corporate profit volatility.

So he created a measurement called CAPE, cyclically adjusted price earnings, to kind of attempt to smooth for some of that volatility. And I think the idea sounds compelling enough, but the execution of his actual metric when back-tested has led to some really self-defeating results. It does us no good to create a metric that basically says the market is always overpriced because obviously by definition it can't always be overpriced.

Hopefully you don't need me to explain that much further. Look, many academics have discovered flaws in this formula, but for me to get into those, it would be in the really, really deep end of the pool. The rationale has flaws, and we do not use Shiller's P.E. measurement as a useful tool in evaluating stock valuations. We certainly do use a plethora of other valuation measurements. Another question from a reader, when do you think the continued froth we're seeing in high dividend stocks will fall out of favor? When do you think the continued froth we're seeing in high dividend stocks will fall out of favor? We wouldn't dare to put a day, week, or month on it, but substantively we think it'll be when valuations bubble over or when bond yields rise and spreads compressed to the point that those high valuations no longer make sense.

We see low yields and low growth on the horizon for quite some time, meaning there should continue to be appeal in this sector of stocks, yeah, even to the point of excessive valuation. In the deep end of the pool this week, and if it does sound redundant, forgive me, I want everyone to understand this basic tension that we are dealing with in capital markets. So I promise you this isn't the first time I've gone through this and it's not going to be the last either. Essentially, the Fed's in a desperate need to somewhat normalize monetary policy or they risk severe distortions in our own capital markets. However, they're stuck in place by the extraordinary conditions around the

globe that have resulted in negative yields in Europe and Japan, etc. If the Fed tightens our monetary policy, the dollar will rally and our risk markets will sell off and that will reverse the effects that they're going for. Period. This is the tension and there's not a simple way out of this, but their delay in normalizing is just making things worse. delay in normalizing is just making things worse. The complexity and tension comes from this issue. How does the Fed normalize when everybody else is doing the exact opposite? The weekly reinforcement of a permanent principle this week, historical charts tell us how things turned out. So when there are bad periods that we visualize on the chart, we are also seeing at the same time the subsequent recovery out of a given volatile period. When we're actually going through

the volatile period, there's no chart showing us the happy ending. Our faith is being tested, and the worst and most expensive words in investing history often get uttered. What if this time it's different? So we are sympathetic to those whose faith in their own long-term strategy gets modestly tested with each new bout of volatility, because indeed they don't get to see the ending, like a chart shows. But we're not, and simply cannot be, sympathetic with those who succumb to that test. and simply cannot be sympathetic with those who succumb to that test. Feeling bouts of fear is normal when investing in risk premium assets,

but giving in to that fear is fatal. The Bull in Us this week wants to say that it is obviously no secret we're big fans of the MLP model. Oil and gas pipelines pay attractive dividends to investors at a tax advantage and seek to grow that income year over year as volumes of oil and gas that run through those pipelines increase and as the number of projects that they have moving oil and gas increases as well. The business model has been in place a long time and performed remarkably well for investors who want attractive income and attractive growth of income. But it's been subject on several occasions to significant downside volatility

where the prices of company stocks suffered large declines even as the income they paid out did not. 2008 was a great example of the MLP volatility and 2015 was as well. True to form, 2009 was a great example of the MLP volatility, and 2015 was as well. True to form, 2009 was a huge recovery for MLPs, which extended well into 2010. And likewise, 2016 so far has been an impressive rebound for a space brought under much distress by the oil collapse of 2014 and 15. the oil collapse of 2014 and 15. Our exposure here has helped our 2016 asset allocation results and frankly we can't help but notice that the yield spreads with MLPs are still very very wide over their historical level historical levels whereas with most other yield heavy sectors they've dramatically compressed.

In other words, in a day and age where superior income matters a lot to investors, they're still being gun-shy when it comes to this sector. The events of 2015 have left people scared, and while prices are higher and lessons have been learned about the volatility embedded in the space, the yield levels say that there is room to go. embedded in the space, the yield levels say that there is room to go. Funding still matters to afford their growth, as does distribution safety, so each company must be evaluated individually, but we are bulls. The bear in us this week wants to say that when a company believes the greatest use of shareholder capital is stock buybacks versus robust dividend payments,

we think there often, not always, are less than stellar motives at play. Bonuses tied to earnings per share, for example. And we think that the delayed monetization, like a dividend payment would create, extends and expands risk. Many companies do both, share buybacks and dividend payments, and do so robustly. Those companies that are high free cash flow generators. But we are bearish on those who are suddenly devoted to buybacks, often with borrowed money, and who shun the discipline of dividends to shareholders. and who shun the discipline of dividends to shareholders. Switching gears outside the role of investments, please talk to the Bonson Group if you have any questions about your selection of a successor trustee in your own estate planning process,

who makes a good trustee selection, criteria to consider, what corporate trustee options might want to be looked at, and who we work with in that regard. We have a lot we could say about this that may be very useful in your own planning. Practical stuff. Our chart this week in dividendcafe.com is really worth looking at. It's titled The History of This is the Top, and we think you'll find it amusing and possibly educational as well. Howard Marks said in our quote of the week that here is the tradeoff of Dersification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term. True words indeed. It really has been an interesting week. Enjoy your weekends. Enjoy the summer outdoors. May your stock holdings

be filled with robust dividend growth and may all sensible and reliable investment returns be made available to you. Thank you so much. Reach out anytime.