The Dividend Cafe - April Showers and May Flowers

Episode Date: May 1, 2020

I learned a lot in the month of April as well, and I want to share it with you today.  I am either excited to tell you or sorry to tell you that this week's Dividend Cafe is the longest one I have ever written, but also the most important one I have ever written.  The length of it is just simply because of the sheer ambition of all I am trying to cover this week.  There are some investment opportunities that have been created out of these last two months that warrant the attention I have given them this week.  But there also are lessons learned and principles reinforced that I am excited to share. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Hello and welcome to this week's Dividend Cafe podcast. And for a few of you, the video, this is David Bonson. I am the chief investment officer and managing partner at the Bonson Group, recording from the home study here in my house in Newport Beach. And I think it's going to end up being one of our longer Dividend Cafe recordings this week. One of the reasons is I'm committed to try to cover all the topics this week that I cover in the written Dividend Cafe, which the written one is definitely the longest that we've ever

done. Dividend Cafe, which the written one is definitely the longest that we've ever done. I'm recording the middle of the market day on Friday. And as I'm recording, the market had been up a thousand points on the week, Monday through Wednesday, and is down a thousand points on the week, Thursday and Friday. I don't know where it'll end up for the week, but we're actually flat on the week now, even being down a thousand points in the last couple of days. So I'm not going to spend a lot of time talking about what the market's done in the last two days or four days or what it's going to do in the next two days or four days. I have a lot of other topics I want to cover this week, but that issue does sort of tee up. What I think is the most

important thing I'm going to say this week and what I led off in the written dividendcafe.com with. And I allude to this sort of tension that I feel week by week in the writing of Dividend Cafe. And I don't expect people to fully understand it, but the struggle is real. And I want to unpack it a little for you. I very much believe that the Diving Cafe is at least intended to be worthwhile for our clients and to a lesser degree for readers who are non-clients. There is a high degree of conviction and I hope at least some of the time value that can come out of that material. The perspective is ours.

The perspective is not shallow in the level of work and research and contemplation that has gone into forming it. And so I hope that there is a combination of both long-term wisdom and short-term execution that is worthwhile in the way Dividend Cafe is articulated week by week. And yet I am constantly reminding myself, and this is where that sort of tension comes from and even gets to things like me talking about the market was up this week or down this week or whatever, that I have never seen a client's financial goals undermined by something that was addressed in Diven Cafe weekly market commentary like that. We thought the Fed might do this and they did that instead. And it and it changed our whole financial apparatus.

I've never seen a view on a sector that then four months later we might have a different sector in either now or four months later or what have you. That viewpoint resulted in either the achievement of a goal or the undermining of a goal. resulted in either the achievement of a goal or the undermining of a goal. And so is that to say that the things you write about are not important if I'm suggesting that they don't make and break financial goals? It's not so simple. What I'm getting at is that somewhere between 97% and 99.9% of the time in all of my years investing client capital, I have seen

basically one large major category that has a lot of subdivisions within it represent the either success or failure of a financial goal. And that is investor behavior. And out of that, what I mean is the propensity for an investor to feed off of their own human nature. That in a period of accumulation, the temptation to accelerate one's own accumulation of capital with over-concentration, with excessive leverage, with what we call too-good-to-be-true-ism, can't-miss things that they have to swing for, those types of things which are never going to go away. And we've seen them so many times I can't even count. They destroy financial goals. And on the flip side of that, which is far, far more appropriate in the context we're

in now with the with the severe market distress that people saw in the month of March and the really quite serious uncertainty that exists in both American and global economy right now, I believe that the fear side of human emotion can give way to a panic and then out of that panic behavior that can decimate one's chances of financial success and the goals that they may have. And I believe that if there was only one thing I could ever really, really instill into the clients whom I serve, it would be the necessity of behavior, avoiding big mistakes, and staying faithful to behavioral wisdom that will allow for their financial goals to be achieved, to accumulate capital without intervening mistakes, and in their spending phase of life, whether it's for kids' college, grandkids' college,

quote-unquote retirement, I more and more hate that word. But my point being the spending phase, a withdrawal of capital phase that everyone will have to one degree or another in their lives to allow that to take place safely and robustly without intervening mistakes. And so to the extent that I'm not sure that Dividend Cafe and what it covers week by week is necessarily getting to the heart of what really will either make or break a financial goal, I wonder sometimes if the amount of attention that is put into it is proportionate to the value people are getting out of it. But I do believe that the material being covered is important.

I want more informed clients. I want clients to take an interest in monetary theory or economic theory. And don't worry, we're going to have some of that here in just a moment. But I don't want those things to ever be portrayed as we look to sort of analyze the ad hoc realities of the health pandemic right now, or what we believe the Fed might be doing a couple quarters out, or the state of the American energy sector, or all of these types of things. I want it to be valuable, but I don't want it to be presented as anything other than what it is, which is information that develops a knowledge base that then is incumbent upon us to apply with wisdom and to do so in a manner that will facilitate client goals. And what the clients

have to do then is avoid the mistakes and demonstrate the behavior that will help that whole plan and process play out successfully. So that's what we do. And I hope that this setup for you just gives you a little glimpse into my thinking as to what I view the value of Dividend Cafe to be and what I view the value to not be. And with that said, let me jump into a lot of the topics that are kind of present right now. I think when you look at a stock market rally in April, it was the biggest month in the market since January of 1987, 33 years. So the S&P was up over 12%. The Dow was up over 11%. It was a very good month for the dividend growers and the areas of the market that we really believe in. A lot of the financials and energy companies

had a big rebound. It's kind of odd just because the lockdowns aren't even done yet. And we're by no means even through the worst of how bad the economic damage is going to get, let alone been able to start to measure the economic recovery. No matter who you're talking to, the economic recovery is coming third quarter or fourth quarter or first quarter next year. It's not coming now. And yet the markets had begun to kind of rebound off of those March panics. And yet the volatility still remains very high. The VIX is still well into the 30s, perhaps going to get back into the 40s. And like I said earlier, at least as of the time I'm recording right now, the market had

gone up 1,000 this week and has now gone down 1,000. So volatility remains consistent. So what in the world could explain why equities have done so well in the last week until the last couple of days, the last month, and why they may very well do better than a lot of people have expected throughout this pandemic period and economic uncertainty? That TINA trade, there is no other alternative, excuse me, is incredibly important right now because of the Fed and because of a zero interest rate policy. Before we had zero

interest rates, which we've had for a whopping, you know, what, six weeks now, six or seven weeks. Before that, the 10-year was at 1.5%. In every bear market we've had that I studied, going back 10 bear markets, the competitive interest rate starting the bear market was 4%, 7%, 5.5%. So people had the ability to say, we're in a bear market, we're in a recession, we're in bad times. I would like to go make 50 grand a year on every million dollars of investable capital I have while I wait this out. Right now, they can't make $6,000 a year on a million dollars of capital with a 10-year treasury bond. I mean, think about what I just said. Million dollars of capital and your interest rate will pay you aboutfree alternative, you can probably then do a little bit of guesswork to say that even if you consider large cap U.S. stocks to not be the safest thing in the world,

stocks to not be the safest thing in the world, next to European stocks, next to Japanese stocks, next to Chinese stocks, next to commodities, next to a whole lot of other things that might exist on planet Earth, or other coupon-paying instruments. You say, OK, our treasury bonds are real low, but what if I go into these other types of either high yield bonds or what have you, that either in safety, there is a virtually 0% income in return. And in risk, there is a relatively better risk environment for US stocks, particularly large cap, than the rest of the world. Does that mean that US large cap stocks don't have risk? No. Does that mean that there are not plenty of people that would rather make 0% in cash than take on the volatility of the US stock market? Plenty of people would. But it explains the relative framework that we're talking about that makes a lot of past events somewhat obsolete because the compelling case

for TINA, there is no alternative. And the relative value of equities compared to the other past likely replacements in volatile periods, cash and treasuries, it's very different. And I think that helps explain a lot of why I expect the investing world to maintain some appetite for U.S. stocks, even as we have to sort through inevitable realities of bear markets and recessions. Then you get to that point, though, where you also beg the question a little bit about the recession. How long will it go?

How deep will it go? When will we come out? And how will we come out? And no one knows the answer to any of those things. But here's what we do know the answer to. come out. And no one knows the answer to any of those things. But here's what we do know the answer to. Historically, the market has led the exit of a recession by six months. And this is a very important fact that I read about earlier in the week I want to remind you of. That has nothing to do with when we know we're out of the recession. That's when we have the information with the gift of hindsight to look back and say, hey, look, the market went up on this date and we

were out of the recession on this date and there are six months in between. But we generally don't know we're out of a recession until even three or four months or longer than we were, which means sometimes there can be in real time 10 months or longer between the time the stocks have begun going up and the time that one knows they are out of a recession. You follow what I'm saying? So I think to appreciate the reality of equities as discounting mechanisms and forward-looking vehicles and the historical reality that stocks lead out of recessions much more than the GDP growth itself does is very important. But then now we have this whole conversation around earnings, which are very opaque and very questionable because of coronavirus, because of the economy being shut down.

And when exactly earnings growth will be able to reestablish a footing. And yet I also have to remind myself, not to mention others, that the vast majority of stock price movement coming out of a recession initially is not that the earnings acceleration itself has taken place. That comes later. is not that the earnings acceleration itself has taken place. That comes later.

It's initially an expansion of the multiple. The price-earnings ratio, the valuation, elevates first in anticipation of better times. And then, of course, the better times themselves come and manifest themselves in the form of better earnings growth. And so it kind of undermines the possibility of waiting for it or timing it. It just simply doesn't work. And it also provides a lot of explanation to why sometimes things may seem to be going better than you think they ought to be. None of which is to argue against the reality of a choppy market, of a range-bound market, or even a potential reversal in markets.

The health pandemic is real, and there's some charts at Ebony Cafe to kind of illustrate where things stand. But as far as the improvement in case growth, in our capacity for daily testing, in decline of daily mortalities. And also where I think it's probably the most important element from a, well, certainly quality of life and human life standpoint, but also the economic measurement of risk is hospitalizations and our kind of capacity to treat things. That was really the heart of the matter in March, when so many believed that we were going to overwhelm the American health system. And the fact that the hot areas, so to speak, you know, New York has still had 33% of coronavirus cases in the country and 36% of mortalities, and yet they've had a 75% to 80% decline in hospitalizations.

And so we're just in a significantly different outlook in the present tense and future tense around the health pandemic. And that's a very encouraging thing right now. But is the data necessarily as optimistic as we wanted it to be at this point. I still feel like there's a little bit of we're there, but we're not quite there yet. Like the case growth has declined. But as far as then getting it to a plateau and then and then really getting, you know, all the way down to the zero range or experiencing some of what they were able to see in South Korea, Taiwan, what have you, we haven't quite got there. We have work to do. It's largely in specific areas.

It's not a 50-state issue right now, and that's a good thing. But there's more work to be done, and we'll see if, in fact, that case growth really drops next week the way a lot anticipate it will. But my point being that the worst risk of the health pandemic has largely been priced away. And most of the risk right now and uncertainty is not in how bad coronavirus gets, but in how long and how bad the economic damage from the shutdown gets. And we just can't begin to answer that question until the shutdown ends. And so hopefully measured, safe, and yet earnest efforts to reopen the American economy will begin very soon.

Out of the reopening of the American economy, I'm spending a lot of time thinking about what are the areas that are opportunistic, what areas we want to be focused on. And I do believe structured credit, as I've talked about. I don't want to get into the granularity of what all this means, but the securitization of cash flows around residential mortgages, commercial mortgages that created a kind of asset class of bonds that we call structured credit remains very dislocated. call structured credit, remains very dislocated. There are structures in place that remain with very, very low historical, if any, default rate whatsoever, and yet have seen their spreads widen and still hopefully represent the opportunity for investors that they've historically represented with spreads this wide. So there are some charts and kind of elaborations at Dividend Cafe around the commercial mortgage market, the concept of a credit risk transfer in residential mortgage-backed securities, whereby Fannie and Freddie in 2013 and 14 began selling off part of their book.

So these were conforming loans that were underwritten to Fannie Freddie standards, but then were transferred off into the private sector. So they now have a lot of the Fannie Freddie components, and they kept a tiny bit of skin in the game, yet they don't have the full faith and underwriting of the United States government behind them. And so that credit risk has been transferred in the private sector, and that has allowed for a really big disconnect in these pools of residential mortgages from those that still maintain what we call agency Fannie Freddie bonds. In a lot of these sectors, the dislocations, the spread widenings,

I think, are out of proportion with the risk and have created an asymmetrical opportunity for reward. Read about that at Dividend Cafe. And of course, we're going to continue talking about it. Interestingly enough, as we've had just a couple of weeks of cartoonishly odd headlines in the oil sector, the midstream energy space has just got done having its best month of all time. Now, its drawdown was so severe from peak to trough prior to April, but even basically five weeks in a row at roughly a 7% to 8% weekly gain, it's still uh not recovered obviously everything it was down but really significant gains in the energy space and i think a greater understanding of what names

are very likely to persist uh you saw some dividend maintenance and even dividend growth and some of the high quality names and energy midstream this week and how those names business model storing excess oil and gas and transporting natural gas, which is in high demand and crude oil, which obviously has had its demand right now evaporate. But we face a future that requires oil and gas to be produced in our country more and more. And even as that overall production is right now facing severe headwinds, the midstream sector and its business model not only had a great month of April, we like where it's headed in the names we're in. 30 of the last 90 years, the S&P 500 had negative earnings. It made less money than the year before. And yet in those 30 years, 77% of them were up years in the market.

This is not to say that as earnings have completely cratered around the economic shutdown, that we expect stocks are going to be up on the year necessarily. It is just to say that if stocks are up in a period of earnings deceleration, that is almost 80% of the time the case. It is not the exception. It would be the rule, more or less. The 23% would be the exception to the rule. It would be the rule, more or less. The 23% would be the exception to the rule. And there's a lot of reasons for that. Most of them are, by the way,

connected to the point I made before of stock price recovery predating the GDP recovery. But I think it's important for us to keep that historical perspective. I put a chart of that at Dividend Cafe. As well as a chart of the infamous weeks in March, the amount of selling pressure that existed in just bond funds alone to be able to visualize over $100 billion of forced bond redemptions from the mutual fund world in just a matter of about 10 days is surreal. And that illustration indicating why exactly that liquidity pinch was so severe. There is a long period, a long portion, not too long. I don't want to give the impression it's some boring thing,

but I tried to really do as good a job as I could unpacking the monetary theory and I think the broader economic theory behind why we believe the efforts of the Fed right now are deflationary, not inflationary, and why the overall debt cycle we're in is deflationary and not inflationary. in as deflationary and non-inflationary. And how the velocity of money works, the concept of money turning over in a society when there's greater demand for money and greater demand for transactions. So that essentially, if one ever wants to stimulate economic activity or for some reason want to stimulate inflation, it would come from the greater production of goods and services, which then triggers velocity of money, which when combined with a big increase in the money supply, we know from Fisher's money theory, that creates inflation.

That's the price theory of money. However, what you have to understand is that the decline in demand for money comes from a weakness in production goods and services in the economy that then feeds on itself. To the extent there's more organic production of goods and services that are met with customer demand, you get that animal spirits. It is not Keynesian. It is far more supply side. And yet you feed on yourself. And to the degree that at that point, money supply was accelerating, you would end up, because of higher velocity, with inflation. What I am suggesting to you is that those that are worried about inflation right now are not wrong to be worried about something. They're just worrying about the wrong thing. The deflationary pressures that compress demand and compress productivity

from the economy is the far bigger issue long term. So if you've heard all this and this stuff sounds like something you're interested in getting into a little more, please read Dividend Cafe. The stimulus that has passed, I'm not counting the monetary stimulus and the Fed. The fiscal efforts so far alone amount to over 20% of GDP as we project them out with the leverage put on and the kind of whole package. Phase four is very likely coming as well. And this has all been done, as you know, in less than two months. There's a chart at dividendcafe.com contrasting the level of stimulus as a percentage of GDP that we did in past slowdowns and the amount of time that stimulus played out. And so one can see why the

magnitude and the speed of the stimulus is categorically different than anything we've ever seen, for good or for bad. But my point being, it certainly isn't for nothing. It is to be understood as a rather gigantic economic occurrence and therefore impacts the way we view the potential ways that the economy will play out in the months ahead. The Fed this week reinforced their kind of support for certain markets. There was no real earth shattering news. The Bank of Japan went a little more accommodating than people were expecting. The European Central Bank, I guess, went a little less accommodating whenever 750 billion U.S. dollars is less accommodating. But, you know, the Fed

certainly reiterated they're going to continue bond buying as much as they feel they need to support financial stabilization. And they're going to keep the interest rate at zero as long as the eyes can see. I did even revisit our kind of politics and money section, sort of proposing a little contrarian theory out there that although I believe it's becoming less likely that Joe Biden is going to select Elizabeth Warren as his running mate to be VP, I'm not totally sure that that's exactly the great thing a lot of markets might want expected to be, a lot of investors might, to the extent people would view Elizabeth Warren as potentially a liability for markets, her not being named VP means she's still out there for a regulatory role, a treasury secretary role, a cabinet role.

So I'm kind of throwing my own little twist on the idea that there is that political nuance to be thinking about. But overall, I stand by my theory that markets are not thinking about the presidential election right now much at all. Just like most citizens probably aren't. It's so far away, so much still can happen. Okay, well, I'm coming up on the 30-minute mark that I told myself I was going to stick to. So I'm going to go ahead and end the podcast here. I appreciate you bearing with me. We did cover a lot of ground. There are really so many charts and elaborations of things at DividendCafe.com. I'd love for you to check that out. And to the extent, I don't think I've said this through the whole coronavirus period,

but if you would like to share this podcast or video with others, if you would like to rate us on iTunes or Stitcher, whatever your player is, write a review, any of those kinds of things, we certainly appreciate it. It really helps the way that those things are measured and scaled. So please do so if you are so inclined. And beyond that, reach out to anyone at the Bonson Group anytime, anything we can do to help you, we're here to do. Have a wonderful weekend and please be well, be safe and be free. Thank you for listening to The Dividend Cafe. services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities.

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