The Dividend Cafe - Crazy World, Crazy Market - August 22, 2019

Episode Date: August 23, 2019

Topics discussed: Chief Investment Officer David L. Bahnsen unpacks everything from the market’s response to "the trade war" and the "the rate war" to where things stand in the ongoing efforts with China, to what the Fed is doing, to the way people are ventilating about the yield curve. Market Volatility The Trade War The Fed and Interest Rates Yield Curve Inversion and Recession Fears Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. particular week, we've actually had a couple other additions to Driven Cafe. We want to try to be doing about two or three per week, but always have at least one of them be just me solo bringing that kind of weekly market commentary, weekly updates and so forth. And yet still within your feed, we'll have some special additions here and there. I did one on Sunday that probably was hitting on Monday that was meant to kind of update our recession outlook. I'm going to talk more about some of that stuff here today. And then we did one with my partner at the Bonson Group, Kimberly Davis, who runs our fiscal feminist property. And Kimberly and I had a wonderful talk about a whole lot of different issues, financial planning, investments for women and all kinds of things.

But I know a lot of you listen for the kind of bread and butter weekly update. And I'm not only going to bring you the bread and butter this week of everything going on in the world right now, and it is a crazy world, it is a crazy market, but I'm even going to title the different things we're talking about around their very broad, basic kind of categorization. Let's talk first and foremost about the latest in the market. Okay. Then we're going to move on to the trade war, interest rates, yield curve. And if I still have some energy, we'll go through a couple other things at the end. But the latest in the market. Well, hear me out on this. I'm recording right now on Thursday morning. The market is up 100 points.

now on Thursday morning, the market is up 100 points. Yesterday, I believe the market was up approximately 250. We were down 100 and something on Tuesday. We were up 300-ish on Monday, or 250 on Monday. And last week, up 300 Friday and up 100 Thursday, but we were down 800 Wednesday. So you probably didn't write all that down, but let me just do the math for you. We basically have had a whole bunch of up days that offset the big down day. Prior to that, we were down 400 on Monday and up 400 on Tuesday. So there is still from a little ways to go back to the all-time high again, but about 75% of the recent market drop has already been recovered. And it's been recovered with something like an average of 350 points per day movement,

one way or the other. And yet, from the beginning of last week to where we are now, market hasn't moved one point. We're just right flat. And yet with an average of 350 points intraday per day. So I actually have a chart at DividendCafe.com. And I can explain it. It isn't necessary for you to see the chart. But in our chart of the week, I show distribution of daily returns going back this full 10 years.

And it's fascinating. And I want you to understand why I'm bringing this up. The market over the last 10 years is up 400%. And yet in the last 10 years has basically had the same amount of down days as it's had up days. And it's had 400 and something even days. And it's had, you know, oh, I think 1200 days where it was down barely at all, all the way up to up barely at all. So there's obviously always that kind of very limited daily movement. But then you look at bigger days up, bigger days down, and you get kind of a distribution of

returns. And even going back all the way 100 years, 54% of market days have been up. That's more than 50%, like in the last 10. But still, 46% of days have been down in a period of time where the market has gone up and quadrupled over itself so many times it's not even funny. And the reason I bring that up is that in this period right now, it exacerbates the importance of people understanding. It highlights the gravity of this message. That intraday maneuvering, the attempt to formulate an investment policy around the daily market volatility is utterly futile. It cannot be done. It will not be done. It will cost you the upside of recovery and the upside of letting an investment strategy that's designed to succeed

play itself out. It will create strategies that are actually inherently designed to fail, unless one believes that they have the capability of doing something that no investor in history has proven they have the capability of doing. It's a rather arrogant thing to assert, don't you believe? So as far as the market right now, it has recovered and I'm sure some people are happy about that, but it has not given us any indication that the volatility is going away. Intraday volatility, day-to-day volatility, weekly volatility continues. What's the latest in the trade war?

Not any significant newsworthy events this week. President's continuing to talk very tough. Some of his key personnel, leaders, cabinet, things of that nature, are supportive in that kind of tough talk with China. The Chinese currency has reached an 11-year low against the dollar. So we understand the way in which China is softening the impact of the trade war on them through currency weakening and exporting that impact to others. And by others, I mean basically those who are transacting in dollars. I mean, basically those who are transacting in dollars. But from the U.S. side, there is still 10% tariffs that are going to be kicking in in September on a lot of consumer products.

Now, about $160 billion worth have been delayed over into December. The administration has backed down a bit on some of the restrictions with Huawei Technologies. So there's some limbo around the kind of timeline of some enforcement and things like that. But here's another issue that I sort of have been thinking about this week, and I think it's important for you to consider this. If the governing narrative is that China right now is saying, look, let's just wait Trump out. He has a chance of losing midterms, maybe even a really good chance, not midterms, the presidential election. And then we'll get a better deal with the Democrat candidate. You know, that's been my kind of theory for a little while. That makes the most sense, that they don't have a need to make a deal. They're happy to take on Chinese economic pain without any political aftermath like we would

have here in America. And then to the extent that let's say it were a former Vice President Joe Biden who became the next president, I think the Chinese would be right. They'd end up getting a much better deal. There would be no real reason for them to have to go negotiate with President Trump right now, at least beyond anything kind of superficial and short-lived. But let me ask you a question. What if Elizabeth Warren is the nominee? See, Elizabeth Warren is far to the left of Trump on almost every issue. And by the way, she happens to be extraordinarily far to the left of where I am personally. But on China, it's kind of interesting. She represents a weird conundrum because she's the one climbing the fastest in

the polls, even though Joe Biden is still in the lead, I'm not sure that the Chinese would like to wake up and say, OK, now we got to do a deal with Trump or would like to wake up and say, now we got to do a Warren in the sense that both of them represent a different variation of hardliners against China. So if the political calculus has been let's wait out the election, but if Elizabeth Warren is the one gaining momentum versus some of the others that would not necessarily be China hardliners, you have the potential for this whole political calculus getting shaken up yet again. So food for thought there. As far as the interest rate war, the back and forth with President Trump and the Fed, where exactly the Fed is, we are now pricing in in the Fed Funds futures market a 100% probability of the Fed cutting rates at the September meeting by one quarter point. Meaning there is not even right now the market indicating a chance of 50 basis points of a half point, but certainly also not pricing any chance of no cut. They're basically saying it's going to be a quarter point in September.

And then where there is some ambiguity is in December. There's a 40% chance of one more cut in December. There's another 40% chance of two more cuts in December. And there's roughly 20% chance right now of no cut in December. So if the possibilities are that the Fed funds rate is going to end this year, either one quarter point, two quarter points, meaning a half point, or three quarter points lower, our view is it will end up being in the middle there. It will be a half point decline.

And that's obviously those odds have increased dramatically through all the volatility of markets in the last couple of weeks. Now, the yield curve has behaved. And people's response to what's happening in the yield curve has been a lot calmer, a little bit more measured this week. And I myself have really gone to great lengths to try to develop at least as reasonable and sober minded of understanding of the issues. Because if you're going to say something like it could potentially be different than it's been in the past, you have a high burden. But saying something that might be different than it's been in the past is not saying the impossible. Things often might play out differently than they often have in the past, especially when

the past itself was not 100%. You know, there are plenty of times in the past that the yield curve has inverted and we did not go in recession. Now, it's not a lot and it's not the majority, but there have been times. So if we're going to look at what has happened here, as I pointed out in the podcast last weekend, we have to kind of deal with the fact that the yield curve did not stay inverted. You know, we had in these past yield curve inversions multiple months. And by the way, most recently, 2005 and 2006,

we almost had a full year. I think it was 225 days of just from the point at which the yield curve inverted to where it maximized its inversion. The actual total period of inversion was even longer. And here we were inverted for, you know, less than a couple hours last week. And then it re-inverted for about five minutes yesterday and five minutes today. And it's right flat between what the two-year treasury is and the 10-year. And as I'm talking, I'll even look up where it stands right now just to give you the most updated number. But my point being that you first of all have to look at kind of the facts surrounding the event itself. But then when you look at the causation, I just think it's legitimate to point out, you know, right now it's literally exactly flat as I'm talking the two years at 159 and the 10 years at 159.

You have $15 trillion of debt around the world that has a negative yield. And you have an unbelievable amount of people that feel quite confident in the U.S. government's ability to pay back its debt. You have a dollar that's a world reserve currency, and therefore a lot of significant sovereign and institutional money that says we would rather buy the U.S. Treasury at 1.5% 10-year than a German 10-year that is negative 0.5%. So as all that money is pouring in to U.S. bonds and out of global alternatives, it has the obvious net effect of pushing the price of our bonds up and the level of our yields down. And so to combine that with a Federal Reserve that had the overnight rate rather tight, relatively speaking.

Extremely tight, relatively speaking. Not at all tight, absolutely speaking. But relatively speaking, quite tight at over 2%. That's what an inversion would do. That's what an inversion would be. Does that necessarily indicate recession? Well, we've never had these conditions before. So we've had the yield curve invert plenty of times, but in this case, there are some

differentiators. Does this mean that I'm saying this yield curve is different? I'm not saying it. I am very open to that idea. What I'm saying is people cannot get carried away around the predictive value of something that A, has differing circumstances, B, has differing manifestation, the way it's even playing out, the magnitude of the inversion, the length of time of the inversion. I think that it warrants a lot of humility and a lot of caution in how people react around it. So I'm going to summarize our viewpoint and then talk about a couple other peripheral matters before I close up. Do we expect the market to make new highs anytime soon? We do not. Do we expect the market to reach the lows of December 2018 anytime soon? We do not. Do we

expect perpetual volatility in the market, up and down movements, potentially 100, 200, 300 points at a time, day by day, until there's clarity on China trade tensions? Yes, we do. Do we expect the Fed will cut an additional 50 basis points, two quarter point rate cuts before the end of the year? Yes, we do. Of course, the possibility is there will only be one. The possibility is there will be three.

Don't see a possibility there will be zero. Don't see a possibility there will be more than three. And between the options of one, two, and three cuts from here, keep in mind they just did one last month in July, we would argue that it will be two more cuts between now and the end of the year. And then around those various things that I just stated, no new high anytime soon, no new high anytime soon, no new low anytime soon, ongoing volatility of China, Fed cutting rates two times.

We favor balanced, even-weight approach to equities for the foreseeable future with an emphasis on undervalued securities, undervalued sectors, and more defensive quality names. Now, there's a problem with that last thing, and that is that I am not the only person in the world that has the brilliant idea of trying to take a little defense in your portfolio around more defensive, high-quality names. So you have gotten a bit up in the valuation on some utilities, some consumer staples, some REITs, some of these higher dividend oriented names. Some of them have gotten a bit frothy. So for us to play out the way I just said, which is both quality, which I like, but has gotten expensive and sometimes gotten expensive. And then undervalued securities, we had to be very selective. And most of that opportunity where we think there's good quality and undervaluation

is in the most out of favor sectors on earth, which is energy and financials. Dividendcafe.com this week, I walked through the last five times the yield curve inverted and exactly what happened, how it played out and why past may not be prologue. Please check it out. What are we seeing in the credit market? What are we seeing? I talk about this all the time. Credit spreads, are they telling us anything I need to know about, anything I need to be concerned about?

It's interesting because credit spreads have widened a little bit, more so with high yield and investment grade. They have not widened enough to make me say, wow, the bond market is really giving you a clear sign that we have systemic distress ahead. It's been a modest amount of spread widening, but it's still worth paying attention to. And yet the absolute cost of borrowing for these borrowers has come down, not higher, because even though the spreads have widened, the reference rates, the nominal yields have dropped so much. So you have slightly wider spreads, but you have a lower cost of borrowing and more liquidity in the credit market than we've had in the last couple of months. And those are not the conditions by which recessions are born. Now, those conditions can change.

But right now, not only are spreads behaving, the absolute cost of borrowing and overall liquidity is reasonably healthy. It's worth paying attention to. I talk in DivenCafe.com quite a bit about hedging equity risk. And that there is a certain level of equity volatility that is sort of unhedgable. Let's call it 3% to 10% of downside. If someone said, I need to put a hedge on that will protect me if the market drops 5%, the reality is that the cost of that hedge is going to eat away

at any potential return up to about that amount. You don't really have a lot of asymmetrical opportunity in hedging. Hedging becomes something that is less expensive to do and providing more of a benefit at larger potential downsides, real significant deflationary drops. And yet there is a deflationary hedge one can buy that they actually get paid to own. And that is, of course, long dated bonds, long maturity treasury bonds have always been a very effective deflationary hedge. And so if your reason to own bonds is offense, you're trying to make money,

then yields are obviously so low that the bond market doesn't present a very wonderful opportunity. But if you view bonds as a necessary element of your portfolio to hedge your equity risk for deflationary circumstances, then the irony is that most out of fear of what their bonds would do if interest rates went higher, loaded into short duration bonds, avoided long duration. And yet the great hedge against the deflationary risk that represents the main reason you own bonds was not forfeited, but it was diminished. You got a lot more of a hedge out of long-dated bonds than short-dated bonds. I think people need to sort of determine what their objective is in their bond allocation. Are they trying to make money? Is it an offensive motivation? Let's

evaluate that. Are they trying to avoid losing money? Is it interest rate risk they're worried about? Let's evaluate that. And is it trying to hedge against equity market distress, significant equity distress? Let's evaluate that. Because in each case, depending on that objective, there's likely one scenario that would be a better way to play it than another. Energy markets are certainly very interesting. Oil prices are up over 20% on the year, and yet all we hear is how weak oil prices are. But that's what happens when you go from 45 to 65, and then from 65 back down to 55. It doesn't feel like you're up over 20% on the year, but we are. I think oil has been very short-lived when it's hit the 40s over the last few years,

and I think it's unlikely to happen again, but it could. But again, that $50 range up to maybe $75 on the high side has been the range where prices maintain reasonable affordability for consumers and maintain reasonable profitability for producers. So it may seem like a pretty large range, but 50 to 75 has been the sweet spot. Below 50, you get problems. Above 75, you get problems. We expect shale production will tail down a little bit. It's been incredibly high, and some of the weaker producers financially have been forced out. Marginally weak producers have really adopted more fiscally prudent operating principles in their business. There will likely be more consolidation in the space.

Balance sheets matter. It's a cyclical business. But here's the thing. Demand remains very high. Demand growth in natural gas is even higher. And supply is keeping gas prices down. That bodes well for volume, but not for prices. But they cannot move the amount of gas they're producing. And I believe that whether your thesis is export opportunities, infrastructure, financial strength, discipline, there are plenty of opportunities in the energy space that we think are very opportunistic here from a value standpoint and a yield standpoint. So we shall see what the Fed does here in the next month. We have Japan getting ready to go live with their VAT tax

increase in another month or so. The Brexit deadline is still another couple months away. Hong Kong's tensions are lingering. This week, the president, more or less, especially through a couple of his senior people, announced that they were going to be going forward with indexing to inflation capital gains. And then the very next day, the president came out and took that back, taking, at least for now, off the table a really potentially dynamic stimulus opportunity that would have been very pro-growth. They're throwing around the idea of a payroll tax cut. There's no, you know, it would have to go through Congress. I don't think anyone really believes that you're going to get a big bipartisan tax thing right now. So even apart from the political

infeasibility of it, it's not traditionally been successful as far as generating growth. So the political scene is a little depressing. The trade war issues are out there, and I mentioned some of the other global catalysts. I think the yield curve and trade war will be the main things you're going to hear about in financial media. And so our theme will continue to be understanding the message I shared earlier in my talk that is the chart of the week at Dividend Cafe, understanding the real significance

of daily volatility versus longer trajectories. And right now accepting that you may have work to do with your bond allocation. We're making some adjustments. You may have work to do with the alternative allocation. Within the equity bucket, you want to continue finding the right opportunities. We're very active right now buying on weakness where we think there are good opportunities to buy. We're trimming gains where we think things are a little fat. But ultimately, the principle of having the right plan that is not attempting to maneuver around day-to-day moves in the market is most certainly the most important thing one could try to do. That's my take this week here in the Dividend Cafe. I hope you've gotten a lot out of it. As always, I encourage you to go to DividendCafe.com to look at different charts, read through some of the things I spoke about.

To the extent that you have enjoyed what you've heard today, I would really appreciate you giving us a little five-star rating, hitting the subscribe button, and whatever your chosen player is. Those things help boost up the traffic, boost up the kind of visibility of the podcast. And so it's important that we ask you to do that if you are so inclined. In the meantime, reach out to us at the Bonson Group anytime. Any questions you have through these incredibly turbulent times in the economy and the market, avoid the far extremes of either side emotionally right now. There is absolutely nothing to be despondent about in the economy or in the side emotionally right now. There is absolutely nothing to be despondent about in the economy or in the market for that matter. And there's nothing to be overly

euphoric about either. We have a good economy, but there are some signs of trouble. We have some uncertainties, but some of those uncertainties have a chance of being resolved. And so in the meantime, this is what we're here to do to help guide you through that. Reach out to us. Thank you for listening, as always, to The Dividend Cafe. Thank you for listening to The Dividend Cafe, financial food for thought. The Bonsai Group is registered with Hightower Securities LLC, a member of FINRA and SIPC, and with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free

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