The Dividend Cafe - Chewing on the Four E's

Episode Date: June 24, 2022

I’ll be very honest with you – I prefer single-topic Dividend Café issues. I wrote a multi-topic weekly commentary for many years before moving to a “mostly” single-topic orientation, and I have never loved writing Dividend Café more. I feel that the weekly information quality and value is higher with a singular focus each week, and I think the “variety” style works better in our daily market bulletin that is Dividend Café’s cousin, The DC Today. But today’s Dividend Cafe is a bit different. There are a few “big” issues that people are bringing up daily, and I want to do a little multi-question fireside chat with you. So jump on in to the Dividend Cafe … I promise you’ll find something of interest, and maybe even intellectually transformative! 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 another Dividend Cafe. I am back in New York City. I believe last Friday I was recording from the city, but in my apartment very early. And then I spent most of the week in Grand Rapids, Michigan at the Acton Institute, an absolutely phenomenal economics conference that I attend each year and lecture at myself. I got back into New York City late last night, and I was planning to record Dividend Cafe early this morning again at my apartment and didn't have it done in time and then had various appointments and then was on Fox and then I'm back in the office. So I'm recording now a little later in the day than I normally do.

And the market's in a big rally and I don't really want to talk about any of that. All I will say is, you know, we had a very bad week in the market last week and a very bad week in the market the week before. And this week has been a very big week up in the markets. And I would not say that either tells you anything about what next week will be like or the week after. So just, I wouldn't be taking comfort in good weeks and I wouldn't be getting, you know, despondent over bad weeks. And I've said it a lot. I'm going to keep saying it. But what I want to talk about today is four different things. And I actually changed the title, A Dividend Cafe, when I realized, because I did it accidentally, almost

everything I do that ever seems even remotely clever is an accident. I never do anything all that smart on purpose. And I don't think this is particularly smart, but I just sort of coincidentally, and I mean that, turned out that my four topics all started with the letter E. And so we're going to just stick with this kind of thematic deal about these four E's. But there are big questions that have come into me about earnings, about the emerging markets, about the energy sector, and about Europe. And I want to address all four of those E's, and I want to do it in one dividend cafe, because I think all of them in a weird way connect together, but also I don't believe that this warrants breaking them out over four

separate dividend cafes. So we'll just kind of fireside chat this. And obviously, if it creates a need for extra coverage, we'll look at that here in the near future. The first issue regarding earnings may be most important because it has to do with where markets go from here. And the question I get asked all the time, whether it's in media or whether it's clients or just people at large wondering, hey, is the market bottomed or how can we know it's bottomed or when will we know? And so much of this market downturn is about valuation. And there's two different stories that have played out there. Valuations got hammered in areas where they were just preposterously overpriced excessively overpriced things are down 70 80 and 90 in some cases and that's a lot of the shiny object

stuff that we've talked about within the fang specter in big tech where valuations were really high but but certain aspects of company fundamentals were pretty good. They're not down that much necessarily. Some pieces actually may be around 70%, but more around 50 and other ones maybe around 30. So it's not quite as bad. But again, it's a valuation adjustment. That's the major aspect of the deep level of carnage in markets is where there was a significant valuation repricing. But then the second piece to this is what I wrote about back in February, which was just the broad based repricing that comes with higher interest rates. So that doesn't necessarily lead to 30% drops, let alone 70, 80, 90. But it leads to a

repricing of risk premium when the discount rate, what the risk-free rate you're measuring your projected earning against goes higher, it brings your present value lower. And so I've written about this before and I've talked about it. It's a basic fundamental concept in investing. And we've had some of that play out because we have a higher rate environment. And then, of course, the valuation bubbles that have had to kind of break apart. So then people start saying, OK, well, do you think that that valuation adjustment is near kind of its end? And I say, you know what? In a lot of cases, to be honest, I think it may be. I don't know for sure. The S&P is at about 17.5 times

earnings now. And I think that the markets average 16 times earnings for a long time, but it generally stays above or below its average level. People can say that generally bear markets end when it comes down lower, but it doesn't always have to do that. And a lot of the past comparisons, you have different rate environments. So it's hard to come up with a really pure apples to apples comparison. Certainly like when people tell me, oh, in the early 80s and in the mid 70s, the S&P's PE ratio got down to six, seven or eight times, but the bond yields are at 15%. I mean, it's a totally absurd comparison. So I don't know if we have to go to 14 times or if it just reaches the median of 16 times or if

it stays here and at 17, 17 and a half times proves a bottom. But all three of those numbers are kind of close enough. Like another 10 to 12% is not the end of the world and it could be, you know, less than that. So I'm going to assume for the not the end of the world. And it could be less than that. So I'm going to assume for the sake of argument that the PE ratio is not the major factor right now. And if it is a factor, it's 10 to 15% of one, give or take. Potentially, things could always blow out way worse. But I'm just saying, I think that's a reasonable probability. But then now, I think it's the E that has become an issue, not the P to E, the price to earnings ratio,

but the earnings themselves. Right now, they're still forward-looking. The S&P analyst consensus expectation is for $251 a share in the S&P next year of earnings. It's going to be about 219, 220 this year. 10% growth next year if we're in a recession. 10% growth if we're not in a recession, but there's still these various input price pressures or muted expectations or the different kind of economic headwinds that we're all talking about every week? I don't think so. 10% earnings growth, the Fed is tightening? I don't think so. So I would argue that the bigger thing people have to worry about is where earnings revisions downward start coming in. We'll see how companies guide in the third quarter forward into the fourth quarter, first quarter, next year, etc.

But I would expect that if there is more downside in markets, it might at this point have to do more with actual fundamental earnings. And sometimes it doesn't have to be that earnings are going to go negative, but just that the rate of growth expected of earnings decelerates. That we thought we were going to grow earnings 10%, we're going to go 6%, things like that, that becomes a market factor. So that's sort of the bottom line about the earnings aspect and where markets sit in the cycle. There's a great question out there about emerging markets. Is this story still viable? A very quick history refresher. When I became really, really intellectually interested in this story was the advent of the BRIC thesis, Brazil, Russia, India, China. A global commodity boom that was taking place 20 years ago. And obviously that story was an incredibly profitable one from the beginning of the century

up till the financial crisis. It then became a bloodbath. Then it reflated quite a bit. And then over the last six, seven, eight years has been periods of great success in the thesis and other periods of downturn. And most of the downturn has not been about the idea of economic growth in emerging markets. It's been about currency. It's been about the dollar strengthening and it hurting the just currency adjusted realities of investing overseas. up thesis for me as a where we want to be in growth investing is that we believe there is an earnings growth coming, a population growth, a entrance into the middle class growth in certain aspects of the world that is really secular, really structural, really generational, and frankly, attractively priced. But you get a geopolitical risk, a governance risk,

and certainly a currency risk that comes with it. So with the currency risk, when the dollar generally strengthens and the Fed tightening, usually this stuff would get walloped. And it's down on the year. But across the board, it's down less than the S&P 500, for example. That's not the norm. I do believe we're entering a period where any sign of Fed weakness about their tightening, the market already having priced a lot of it in, the superior earnings growth capacity, the ongoing demographic story, I think that it's a very attractive story. It could be long term. It could require patience.

It will certainly be volatile. Yet we do believe the emerging market story is alive and well and have a both growth play in our growth enhancement portfolio and income expression of that thesis in our income enhancement portfolio based on a particular client's own goals and objectives and what risk budget decisions that we're making as asset allocators on behalf of an individual client. Okay, the energy story. What an incredible set of gains it has seen this year. It has gotten hit harder the last couple of weeks. Question is, well, is that story over? What did we make in the last couple of weeks? Oil went from 120 to 106. Does this mean it's over? I can't stay enough. Unfortunately, you really do have to go to the written dividendcafe.com because I list out, I believe it's eight different reasons why we still think people ought to pay attention to

the story. Some of them are things I don't like. I think that Russia is making gains in Ukraine. And while I do not like that geopolitically, I think it does indicate probably continued opportunity in the energy sector for a lot of things, both short and long term. But there's a lot of other long term and structural considerations as to why the energy story, I think, is still very viable. And that the most recent setback is probably a great opportunity to even add more into the sector. But it is very important to look at it as a trade, as a play. This is a theme, it is a conviction and has a long-term risk and reward component to it. And yet I believe it will offer superior returns where there is cash flow generation.

We get a lot of that thesis in the midstream sector. There's a couple of more upstream and integrated stories that we like. But no, we do not believe the repricing of the last couple weeks means it's over. We did rebalance and take some gains before this recent correction, and that always feels good. But the reason we're doing that is just simply always risk mitigation, not market timing. And that's where we are. So please do look at DividendCafe.com and understand why the exporting of liquefied natural gas, the sentiment that had gone against energy over the

last six, seven years has substantially, and I think permanently reversed. The cultural objection to fossil fuel having been hit a blow by high gas prices and the reality of fossil needs, let alone European situation or Russia. There's a number of themes and ideas that I want you to look at. So earnings, emerging markets, energy, we'll close with Europe. It's a very simple story. We've spent about 10 years as there's been a lot of mutualization in the European bank, the European Central Bank, the European Union, and a lot of bond spreads in more troubled countries economically, like Italy, Spain, Greece, Portugal, came down to be more like Germany, which is the more superior economic bloc in the European Union. And I think a lot of

people, myself included, really started to take that for granted, believe it's kind of baked in. You certainly saw a more healthy position for European banks, European bonds, as we're talking about. And now all of a sudden, the mere conversation about the European Central Bank having to tighten, raise rates a bit, has caused bond spreads in the weaker countries to really widen, especially relative to Germany. And so you see this dispersion divergence between Italy and Spain relative to Germany. I think it's very problematic. And what it is, is essentially, if the Fed's tightening, the European Central Bank kind of has to. And otherwise, if the Fed tightens and ECB doesn't, you really get a collapsing euro, which creates a whole different set of problems. But then if they do tighten,

bond yields go higher in the weaker countries. The growth levels do not allow Italy and Spain to service that debt. The spending levels, the debt to economic size ratio don't allow them to. And so you get a widening spread. The bond market starts to front run this reality. So what does the ECB do? Are they damned if they do, damned if they don't, because they either get a weaker currency by not tightening or you get this really bad divergence in the bond market if they do? Or do they just pray the Fed bails them out, that the Fed taps the brakes a little and allows the ECB to find an equilibrium? Well, I promise you that's what they're hoping for.

I promise you that's what they kind of have to do. And I promise you the Fed what they kind of have to do. And I promise you that the Fed is aware of this too. And there's no way Jay Powell can go say, we need to stop tightening because we're worried about the contagion risk of sovereign countries in Europe. You can't say it. He will present a united message about fighting inflation in the United States and all that kind of stuff. But they are well aware of how this can play out. And there's not many levers ECB can pull to control their own monetary destiny. They're really somewhat handcuffed to the Fed here. And so I do think it's a story. I do think it has risk. And I think it will exacerbate volatility.

And ultimately, I think it'll likely end by the Fed having to just not let it get that bad for the ECB. But I don't know that's how it'll end. I would think that's the most probable outcome. But along the way, I expect it to create more volatility, including in US banks, where there's more exposure to sovereign debt, and potentially in other aspects of the global economy. So those are my responses on the four E's we've covered today. Follow-up questions are welcome. Questions at thebondsongroup.com.

Please subscribe to our podcast. Put in your feed. Thank you so much for watching and listening. The Dividend Cafe. A lot of great charts at dividendcafe.com we hope you'll go there but please do stay in touch because we want to be talking to you throughout this period thanks as always for watching the dividend cafe the bonson group is a group of investment professionals registered with hightower securities llc member finra and sipc with hightower advisors llc a

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