The Dividend Cafe - A World Traveling Investor

Episode Date: September 21, 2018

Topics discussed: The right asset allocation means you're not always following the market moves Japan's economy is a telling story Chinese Tariff Rumor still don't move the market Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson. I am the managing partner and chief investment officer of the Bonson Group, bringing you our weekly perspectives and diatribes around all things market investing related and what an interesting week. Doesn't February seem like eternity ago? Don't hold me to this because I don't know what we're going to do by the time you're listening but we're sitting in the middle of the day Thursday and the markets both Dow and&P, are back to an all-time high. The market's up

about 500 points in the Dow on the week. So not only is it a reasonably big year in the market, but a big week in the market. But like I said, bringing you back to a kind of new high on the year, which really didn't feel very possible for those who remember back in February, March, etc. You were dealing at that time with the fact that markets had really gotten way ahead of their skis. You were dealing with the fact that a lot of tax reform was presumed to be already priced in. So there was a lot of good news, but maybe the good news was already reflected in prices. You were dealing with inflationary scares, the fact of interest rates moving higher. And then shortly thereafter, we took all of that in the loo

and added to it a trade war. So that resulted in about five months of incredible market volatility. Well, here we are, and the US equity markets have continued to rally. And I'm gonna talk here in a moment about the challenges in a lot of international equity markets and the sort of refresher reminder that I think it gives us to asset allocation and a kind of reinforcement of some of the tremendous investment and behavioral principles around the whole concept of asset allocation.

principles around the whole concept of asset allocation. However, interestingly, as we talk about challenges in international markets, Japan has caught a bid in the last five days as well. I want to talk about that this week. So without further ado, let's jump into the Dividend Cafe. Why not just stay home for vacation? Well, if the year we're ending today, the number one story in the world of equity investing would not be that shocking downside volatility I spoke about that we had in early February. It would not be the back and forth challenges of March through June. It would not even be the positive catalyst of tax reform or the negative catalyst of the trade war. No, if the stock market were at December 31st now, and I should point out the obvious, we have three months to go, but the major equity story of 2018 is that equity investing has only been a positive

experience this year in the United States. In 2017, the extremely rare theme we wrote about was the globally synchronized recovery, where not only was GDP growth positive all over the globe, but stock markets were healthy across almost all geographies. Move that to 2018 and you see a negative market on the year in the United Kingdom, a negative market in Europe, a very negative market in China, a negative market in Japan, though the last five days has seen much or all of that reversed, and a negative return environment for emerging markets, so forth and so on. The MSCI World Index is up 4% to 5% on the year, yet the MSCI World XUS Index, meaning the exact same index but with the United States taken out, is down 4% to 5%

in the year. You're talking about an 8% to 10% differential between US equity and everything else equity. I have never seen such a stark contrast between US markets and, well, everything else in a single year. But rather than merely continuing to comment on the facts of this divergence, let's actually unpack it a little bit. What does it really mean for us? Should we have avoided international markets? Should we avoid a global approach to investing going forward? In a six or nine month period when one asset class outperforms another, does that mean that the winning asset class should become 100% of an investor's portfolio? Is global diversification dead? I'm hoping the answers to all these

questions are obvious, but let me address these head on. No, every prudent principle of investing has not become obsolete because of a couple bad quarters in international markets. I believe that this principle will end up being the most important part I'm going to utter here for you on the podcast. The idea that diversifying one's opportunity set becomes a bad idea because one or two bad quarters or the anomaly of a year like this is insane. But to be more forceful, the results this year are not even that much of an anomaly. The dollar has rallied. The U.S. markets launched tax reform. Much of the world economy is slowing while ours is accelerating.

Was this dollar rally foreseen? Quite the contrary. Are emerging markets likely to struggle in perpetuity? Well, if their struggles continue, I might argue one of the great convergence opportunities in decades is coming. The fact of the matter is that asset allocation is built around the idea that an investor is offset downside risk or downside volatility at various points, all the while moving the entire aggregate portfolio up through time. We tend to approach international markets tactically at the Bonson Group, entering Japanese dividend equities just over a year ago, avoiding European equities throughout this debt and currency fiasco, an avoidance that is still going on to this day, adding to emerging markets recently, etc. But we don't regret international exposure when the U.S. outperforms international any

more than we regret U.S. exposure when international markets outperform the U.S. I know of no serious investor, including the best and brightest in the world, who choose to forego the wisdom of global diversification. We have no intention of abandoning prudent investing principles, no matter what the gift of hindsight says in short-term intervals. Now, speaking of Japanese equities, they've struggled much of the calendar year, largely as the dollar has rallied, particularly against the Japanese yen. And this last week or so you've seen a violent rally in Japanese equities, erasing much of the downside of the year. Their central bank unsurprisingly

reiterated a lower for longer theme in terms of their monetary interest rate policy. But what we would point out, what we believe will win in the end, is that corporate profitability is the brightest it has been in over 25 years. The $40 billion of net outflows from the Japanese equity markets at the hands of non-Japanese investors, presumably many from the United States, is as lovely of a contrarian signal as I could have hoped for. Business investment is on the rise and all the uncertainty around future central bank activity is just merely missing the forest for the trees. bank activity is just merely missing the forest for the trees. So if there is an opportunity in Japan, where is it? How does one do it? Our view has been that if we wanted to tactically add this exposure to our equity allocation a year ago, that we ought to do it in a dividend-oriented focus.

We've done this through two actively constructed ETFs, meaning diversified single securities that are constructed around actual factors, not the entire Nikkei index. The equity universe in Japan trades at just 11 times earnings, yet is experiencing multi-decade highs in profitability. Corporate governance is substantially improved, wages are improving, and their domestic health is much better than their export economy. We take on both a large and small cap approach with heavy focus on dividend payers in both. We hedge the currency in large cap but stay unhedged in small cap, meaning we want to be as currency agnostic as possible. I spent a lot of time in the last couple of weeks talking about this debate between active and passive. And I want to kind of apply that same debate in our remaining time to municipal bonds, because we're so used to talking about it in terms of the stock market. Should we have an ETF for the S&P 500 or should we have a more active approach?

And I really kind of went through and unpacked that whole debate two weeks ago. But in terms of the fixed income world, I think that there's another argument to be made that is very much in favor of an active approach, and not just an active approach, but an active approach that utilizes individual bonds, not necessarily a single security, whether mutual fund or ETF. Let me give you a little context. There is an infinite amount of stock available

within reason to a regular investor. A regular investor is not going to go buy so much Microsoft that it moves the market, that they can't get access to the size of position they want. You know, companies with multi-billion dollar market capitalizations and they trade millions of shares per day, they provide an awful lot of liquidity for investors. And treasury bonds are kind of an infinite accessibility as well. The total size of that market's in the trillions of dollars, and treasuries trade heavily across pension funds, endowments, sovereign wealth funds, and even in the retail investor world. But see, tax-free bonds are very different. Pensions and endowments do not generally own municipal bonds because they're already tax

exempt organizations. Foreign investors generally do not own them because they don't receive a U.S. tax benefit. And so obviously, sovereign wealth funds do not own them. In other words, the market for municipal bonds, the customer base, is a tiny fraction of the market of stocks and treasury bonds. So that leads to a liquidity reality. Some bonds get issued and then are just not sold. There are less people owning them and the nature of the asset class is much less turnover driven. It makes replicating an index of bonds with real life bonds very, very challenging in the real world. Yes, one can try to fabricate an index with comparable maturities or credit qualities or coupons, but the fact of the matter is, unlike the S&P 500, the lack of infinite supply means that the vast majority of index funds underperform their own index because the index is a fantasy construction.

But see, to replicate an index, it takes real parts. So what does that have to do with active investing in the municipal bond space? We advocate active management where there can be transparency, flexibility, customization, and significant tax management. Yield curve management is an important aspect of improving the total return in a bond portfolio above and beyond the mere coupon of the bond. Understand and managing all aspects about the call features, the supply technicals, new issuance, other such matters dramatically impact results and do so far more than mere things like insurance and credit

agency ratings. Mutual funds and index funds are deeply affected by what the masses do, whereas active separate account management and municipal bonds transcends these retail characteristics. Executions can be far better this way as well because of economies of scale. So while stocks are a more exciting asset class than bonds, and the entire active versus passive debate is misunderstood and misapplied in any number of asset classes, our comments on the active passive debate is misunderstood and misapplied in any number of asset classes. Our comments on the active passive debate with municipal bonds is that there's a real utility to getting this right. And municipal bonds are not one where you want to be following the herd.

Go to thedividendcafe.com this week to get a chart of the week that pertains to technologies waiting in the S&P 500 and what it looked like 18 infamous years ago, what it looks like now. You'll see a very interesting relationship and why some bubbles are a little more definable than others. Look, my comment to close you out on the market, getting back to these levels, is that the market has shrugged off a lot of the fears about a China trade war around the belief, which we certainly hope is accurate.

We frankly think it probably is. We may not be as sanguine about it as some, but that is the hope that the U.S.-China talks are going to resume and resume effectively and with hopefully a great outcome after the midterm elections. And so I believe that that is helping the markets to focus on the really important things, which are all overwhelmingly positive. And that is dividend growth, earnings growth, share buybacks, CapEx, business investment, corporate profitability, corporate margins, top line revenue growth. OK, these are things investors want.

These are things investors care about. These are things investors are getting in this market. Will it get overcooked? Yes, it will. Is it frothy at this time? Some areas are, some areas are not. Do we want to violate asset allocation by getting out of international equity into U.S. equity, by getting out of bonds, by getting out of our diversifier risk mitigators like alternatives? No, we do not. We want to maintain a disciplined

and prudent asset allocation that manages your risk and reward needs and yet maintains that exposure to U.S. equities, which right now is an exposure investors are very happy to be having. Please reach out with any other questions. Thank you for listening to the Dividend Cafe podcast. I close with this brilliant line from the brilliant Ralph Waldo Emerson, what lies behind us and what lies before us are tiny matters compared to what lies within us.

Thank you for listening to The Dividend Cafe. Thank you for listening to The Dividend Cafe, financial food for thought. Thank you for listening to the Dividend Cafe. Financial food for thought. Investment process is free of risk and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinion, news, research, analyses, prices, or other information containing this research is provided as general market commentary. It does not constitute investment advice.

not constitute investment advice. The team in Hightower should not be in any way liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information or subjects changed without notice. This document was created for informational purposes only. The opinions expressed solely those of the team and do not represent those of Hightower Advisors LLC or any of its affiliates.