The Dividend Cafe - All Time Market Highs Mean ... - July 15, 2016

Episode Date: July 15, 2016

All Time Market Highs Mean ... - July 15, 2016 by The Bahnsen Group

Dear valued clients and friends, welcome to this week's Dividend Cafe podcast. July 15th, 2016. The markets reached all-time highs this week, finally transcending previous levels set well over a year ago. In fact, it set a new all-time high every single closing day of the week from Monday through Thursday night. That may not hold here on Friday. But there's no shortage of questions that remain about the next sequence of events to expect in capital markets. For now, though, U.S. investors are breathing a sigh of relief around the rally that both stock and bond markets have enjoyed. This week, we're going to unpack it all a bit, present our views on where the risks lie, and look at what it means to a real investor. From our executive summary, number one, on the most basic of levels, the facts of the matter are as follows. The world is awash in negative bond yields. There is either zero or negative economic

growth in Europe and Japan. There is slowing economic growth in China and all sorts of complexities around what's going on there. Oil prices remain about 50% off of their highs. The United States has the two most unpopular people in history running against each other for president, and yet stock market levels are at all-time highs. Is this irrational? No, not really. Earnings have been high. Central bank policy has forced a lot of that, and I mean a lot. But they forced a lot into capital risk assets like stocks and real estate.

The flows have pushed in that direction as a result of central bank policy. So it makes sense to ask, is this sustainable? Where is the overall economy really headed? Number two, the much maligned financial sector is where we suspect there may be equity value right now. Number three, the dirty little secret in the active versus passive debate is that many active managers are a lot more passive than you think. Number four, the world of REITs, Real Estate Investment Trust, is one we are invested in, and it's performed remarkably this year. But we want to be careful about interest rate sensitivity. In the news this week, first and foremost, over 80 people dead and 200 more injured in just another

grotesque terrorist attack in Nice, France. A truly horrific incident leading the headlines here today, Friday. Along with that awful announcement is the news of the, along with that awful news rather, is the announcement of Donald Trump selecting Indiana Governor Mike Pence, longtime congressman there, current governor, as his vice presidential choice. And then thirdly in the news this week, markets were shocked Thursday morning, pleasantly so, when the Bank of England announced no change to their interest rate, holding it at 0.5%. A cut of a quarter point was universally expected, as most believe that the disruption and instability supposedly from Brexit would necessitate further central bank coddling. They have not altered their rate since 2009, the Central Bank of England. They did not,

rather they did hint at a change still coming in August though. But it really was impressive central banking. It showed a defense of the sterling pound, which rallied hard on the news, and at least for now, it was an attempt by British policymakers to say that they believe things are under control. In our core acronym, where we evaluate China, oil, the recession outlook, and then either earnings or the election, depending on what E is more pertinent that month or excuse me, that week. China GDP growth results for the prior quarter did come in on Thursday at a 6.7% quarter and expectations were for 6.6%. So reasonably in line, a little higher than expected.

With oil, it shockingly did not really keep pace with equity markets this week. It kind of stayed flat in the $45 to $46 range, even as stocks have broken out to new highs. Inventories definitely appear to be higher than expected, and that's weighing on price momentum. Our recession outlook continues to be that 2016 is unlikely to produce a U.S. recession, but that a 40 to 50 percent possibility exists for one in the middle to late part of 2017. And then earnings season did kick off this week. Only a few companies so far, and they, by the way, did expect better results than had been anticipated, but the real meat of earnings season is just kicking into high gear. Questions that came in from readers this week.

Number one, what do you make of the huge jobs number from June after the awful jobs number from May? Well, the six-month average is more useful to us than just the headline number of one particular month. month average is more useful to us than just the headline number of one particular month. So as pitiful as May's 36,000 figure was and as incredible as June's 287,000 was, month-to-month variance is so severely volatile that a smoothed average is far more effective. And on that front, we have just 170,000 average number over the last six months. Not too hot, have just 170,000 average number over the last six months. Not too hot, not too cold. Average hourly earnings are still low, and I don't believe this report makes the Fed likely to act in September, but overall it was a very positive number, and it rebutted those fears of an imminent U.S. recession. Number two, we know why we own bonds from

your commentary a couple weeks ago, but why don't we own even more bonds considering the high levels of stocks right now? The high price levels of stocks right now, I assume, is what they're wanting to get at. And, you know, it's a good question. We're in a challenging position and wanting to be prudent and careful about risk in the months ahead. And yet we believe that with interest rates so low, the migration from stocks to bonds, broadly speaking, doesn't reduce risk that much. It just changes it. This chart below is actually frightening. And what I'm reading here is a chart we have in our written dividendcafe.com that we'd love for you to go to to see some of these charts. But we have a chart that is showing how much of the return from bonds around the globe this year has come from their price going higher instead of the interest that they're actually

paying. Meaning as yields have dropped, prices have come higher, and that's provided for 90% of the return in bonds. That's completely unsustainable mathematically. So it's not normal behavior. It is very unsettling, and we think it's prudent to balance risk accordingly and on a customized basis to each individual client. Number three, how do you think muni bond investors should handle the rich valuations they presently face and the declining yields that they experience when bonds are called away or when bonds mature? I think that management of municipal bonds that focuses on yield curve, particularly the exploitation of role, meaning kind of actively exploiting where bonds are maturing at and where

you want to be positioned on the yield curve out of a call event, let alone a redemption event. It's really important right now. There is value to be added in that yield curve management. It's very complex, as you can imagine, but it's going to be really important for future returns. In the deep end of the pool this week, I want to say something real quickly. Active management, when we use that term, it refers to actively buying and selling stocks in a dynamic portfolio strategy, like a money manager or mutual fund uses. And passive refers to just merely buying an ETF or an index of a large basket of securities and leaving it alone. So that's kind of some vocabulary distinctions.

And we talk a lot about the pros and cons of active management versus passive management, but we don't talk enough about what may be the biggest elephant in the room as far as that conversation goes. And actually, the biggest elephant, truthfully, is that investors so often underperform their own investments because they make such poor timing decisions and behavioral decisions, selling out at really low prices and buying extra at high prices. So you actually really defeat the whole point of the active versus passive conversation based on investor behavior. But that's a side note. The elephant is the reality of active

managers that really operate more like passive ones. We call it index hugging or benchmark hugging. And it's a contemptible reality of so many mutual funds that use their active strategy to just, and they look like an index anyways, but of course with higher fees. In other words, perhaps the debate shouldn't be which is better between active and passive, the debate shouldn't be, which is better between active and passive, but why one looks more and more like the other anyways. We have a chart in Dividend Cafe that shows the percentage of mutual funds, how much within their portfolio that used to be kind of active share, high amount of activity and value added and different types of stocks that they're doing versus today. And the chart just shows that so many mutual funds are currently charging active manager fees

for a passive approach, and obviously we don't believe that at the Monson Group. By way of a permanent principle this week, many clients are wondering why we're trimming equities here at all-time highs because stocks appear to be picking up strong momentum. And there's truth to the idea that an all-time high should never, ever, ever be defined by its price, but rather by the valuation. In other words, a $50 stock trading at 10 times earnings is cheaper than the exact same stock being $40 but at 20 times earnings. Be that as it may, we are always and forever asset allocators. We believe in the risk management benefits of rebalancing and having a systematic and disciplined approach in the investment process.

A prudent adjustment of the weightings of asset classes within one's portfolio is part of the permanent principle that we believe in, which is that we want our asset allocation to be sensitive to valuations and we want it to be driven by risk and reward tradeoffs. And sometimes that involves trimming a given asset class and sometimes it involves adding to an asset class. give an asset class and sometimes it involves adding to an asset class. The bull in us this week really does believe that the rejection of the financial sector by investors over the last several months has led to some great buy opportunities in the banks, the asset managers, the life insurers. We wouldn't want to buy the entire sector by any means, but the low valuations created by low expectations, which are themselves caused by the low interest rate environment, has given select opportunities around names that do have attractive dividend yields and outlook for dividend growth. I assure you this is a contrarian

viewpoint. The bear in us this week, and we want to be clear, we're not bearish on REITs. We do have exposure to them through one of our managed holdings. But what we're bearish on is those who believe this asset class is immune to the effect of interest rates. We put a chart in DividendCafe.com today making it abundantly clear how inverse correlated REITs have been with yields over time. We like publicly traded REITs. We like high quality real estate assets that are diversified, have growing rent cash flows. There's a good diversification of geography and product, but we invest in a space with the expectation that a meaningful move higher in rates, should such a thing actually happen, would indeed rock REIT stock prices. We don't necessarily mind that risk, but we certainly don't want to operate as if that risk doesn't exist.

We'll switch gears outside of normal investments real quickly and just want to say that from an individual or family standpoint, small business standpoint, the world of health insurance is complicated, tricky, expensive, and a review of present policies when one has a policy outside of their normal employer's group coverage, Or maybe someone who owns their own company, has a limited number of employees. But certainly any private market insurance activity going on warrants review and evaluation of cost and benefits and things of that. And we have people on our network know the space backwards and forwards,

and we would be happy to provide a real valuable overview for our clients. A key financial concierge service that we want to highlight. There's a chart on Dividend Cafe this week serving as our chart of the week that shows the decline of the 30-year treasury bond yield over the last 30 years. And how it has moved from about 20% per year to about 2% per year. And now right now is basically offering the same cash flow for a 30-year lockup of a government bond as the S&P 500 is. And it really is unfathomable development. George Orwell said, in a time of universal deceit, telling the truth is a revolutionary act. It's not always easy for investment professionals to tell the truth.

There's a strong temptation to tell clients what they want to hear or what you believe they want to hear, but it's a matter of moral courage for a wealth advisor to tell his or her client a truth, knowing that it may rub against what a client wants to hear, wants to believe. We become zealous at the Bonson Group and our belief that our whole business revolves around the concept of truth and trust. That we almost embrace the losing of clients if it's ever a choice between the relationship and the presentation of truth. Right now, we believe risk assets are in rally mode, and we do actually believe that has a chance of continuing for a bit based on present sentiment and other circumstances in the global economy. But we also believe that playing for defense right now is more prudent than playing for offense. So we're seeking a mild way to do that, to alter allocations as markets progress, to be firmly committed to the long-term

beliefs and the great companies of our society that grow profits and grow dividends that they pay us, even as valuations do unpredictable things along the way, up and down. But what is the truthful summary in all this? That markets are inherently volatile. They're inherently unpredictable. And anyone telling you exactly what markets will do in the next month, next six months, next year is making it up. The truth is that we do know what disciplines result in investor success, even as we never know what the wind will blow in the crazy world of crazy markets. With all that said, thank you for listening to Dividend Cafe's weekly podcast, and we sure look forward to talking to you again next week.