The Dividend Cafe - Diversify or Diworsify?

Episode Date: May 24, 2024

Today's Post - https://bahnsen.co/3UYlHC2 David discusses recent market volatility, highlighting large fluctuations in the Dow over the past few months. He emphasizes the importance of avoiding high-risk trades and the hazards of following market trends blindly. The speaker delves into various investor sentiment indicators, such as credit spreads and the VIX index, suggesting a current market frothiness. The main focus is on the value of diversification, both across asset classes and within them, to mitigate risk. He contrasts widespread index investing with a more concentrated approach that prioritizes dividend growth stocks. The host underscores the importance of conviction over quantity in constructing a portfolio, advocating for a strategy rooted in fundamental investment logic rather than crowd-following. 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. Hello and welcome to yet another edition of the Dividend Cafe recording live here in beautiful New York City. It's been a volatile week in markets, big drops on a couple of days. Thursday was actually the biggest down day in the Dow in about 14 months. And this volatility has been going on for a while. You know, it's kind of anticlimactic when you say, oh, we're down a thousand points on the week. But then you realize, well, we were up a thousand points last week and, you know, we're kind of just at the same place that we were a couple of weeks ago. And for that matter, with a big rally in May, but a big drop in April and a big rally in March, we're really just kind of where we were in

February at this point. And so that's what our ongoing expectation is, not merely a kind of flattish market, but a flattish market that along the way has non-flat experiences, up, down, up, down. And it kind of can give people whiplash. And more important, you know, because whiplash is solvable, but people getting their faces ripped off in their portfolio is not. their faces ripped off in their portfolio is not. So, you know, being on the wrong side of trying to trade around all this stuff is the only mistake one has to avoid. The fact that things are going to go up and down along the way is not a mistake to avoid. However, there's a few kind of investor lessons in some of this I want to talk about. And very candidly, a lot of these things don't apply to our clients. They don't apply to people who are prone to listening to Dividend Cafe, watching or reading Dividend Cafe because they may already be more

sensible investors. But, you know, when I see things, there's a kind of snippet from CNBC.com that we put in Dividend Cafe this week of investor bullishness hit a six-week high ahead of Thursday's slump. There's sort of an irony, but that's a very well-regarded sentiment index. The American Association of Individual Investors, this AAII sentiment, and it is a reasonably solid contrary indicator. When that sentiment gets very low, it can tend to be an exciting time for equity investors. And inversely, when it gets very high, it can often lead to something different. Now, not necessarily the next day, as might have been the case of this ironic posting this week, but over time. But there's other indicators now, and I just want

to go through a few of them. High yield credit spreads are only about 300 basis points wide. That's reasonably tight. It's not hyper tight, but it's close. But what it means is people are not demanding a lot more yield for riskier parts of credit investing. The VIX, as I'm sitting here talking, is at 12.5. It's been 12. It's been 13. It's been 12. It's been 13. But you know, you're talking about very low, below average level of pricing risk of what people pay because of fear to price S&P 500 volatility.

There's something called out of the money puts the money that people will pay to buy protection against things dropping a lot. And it could be individual stocks, it could be indexes, but the average price level paid for out of the money puts is at the lowest cost in over a year. All of these indicators, you know, by the way, there's another one too that I wanted to point out. The amount of individual investors buying double and triple levered ETFs has come back up. It had been only about $500 million back in 2020, and it went all the way up to $6 billion. And then it dropped back down to a billion and a half as people were getting

torched in 2022. But now it's come back up, not quite to $6 billion, but just a hair below it. And again, maybe they're all geniuseses and maybe it's all going to work out great and maybe it's all very smart trades, but it is definitely retail individual investors that are speculating. And when you see that kind of fervor coming up in a highly risky product like that, when you see a pretty low regard for risk evidenced in risk mitigation prices like credit spreads, VIX and puts and so forth. I just think you're kind of looking at an environment in which things are frothy at that index level. And I think people have to be more careful than following the general crowd. And when I say it doesn't apply to a lot of our clients or Dividend Cafe readers,

it's because I don't think that this is a place people come to follow the crowd. I think it is a place people come for fundamental investment logic. And fundamental investment logic is not going to be rooted in following the crowd and triple levered ETFs and some of the shinier type things one may do. If I'm looking for value that's out of favor, first of all, I'd like to point out that emerging markets, which are doing just fine, by the way, as an index, they're up 7% year to date. Our emerging market strategy is up 10% year to date. But as a relationship between emerging markets pricing and S&P 500 pricing, it's at a 50-year low, a full standard deviation below its normal historical relationship. And the last time it hit this level, it was in 2000. And from the next seven

years, you had a tear to the upside with emerging markets. And of course, you know, U.S. markets went through a loss to decade. I'm not saying that starts tomorrow. I'm not saying it even plays out the same way. I'm just merely referring to a historical relationship of pricing that's out of whack and presents a value, albeit right now, a value that is not being reflected by the crowds. And so some could look at that and say that's an argument against it, where we look at it and say that's an argument for it. Overall, the main issue I want to get to, though, has to do with how we think about diversification. This is a term

that when I come in here week after week and say, I see index investing right now as primarily a way to bet on 10 stocks. You're going to buy 500 stocks, and you're hoping 10 of them that are all very expensive get more expensive. It's very high concentration, about 30% of the S&P 500 rooted in a few names. And the overall S&P 500 trading at a really significant premium to its historical valuation with those key 5 to 10 names at an especially high premium devaluation. And you hope for a certain level of return in the years ahead that has to come from the valuation staying elevated and perhaps

getting even more elevated. And so I talk week after week, reasonably critical of the strategy, not of the timing around it, but just, and by the way, the underlying fundamentals are cooperating. Earnings are growing. The problem is, of course, that's priced in. earnings are growing. The problem is, of course, that's priced in. If earnings were contracting, if you have a recession, earnings drop, all bets are off. You're not just going to see the index level fall because of valuations collapsing. You're going to see both the P and the E, the multiple and the earnings drop, and the P that goes there with in a priced earnings, it would be a bloodbath. But earnings may not do anything like that. And that would be a reasonably good environment to at least kind of hold the line

if valuations weren't excessive. But see, my critique of the environment we're in right now and people following the crowd is that following the crowd ends in tears, and the kind of conventional views right now, I think, are excessively valued and therefore present challenges for longer periods of time. And I'm trying to suggest something that is somewhat counter-cultural, and yet diversification's a very cultural idea. It's a very conventional idea,

and I am a big advocate of diversification. I just merely want to point out that when someone says I want 500 stocks with the S&P 500, or I want to buy six index funds or four index funds, that there is a thing called diversification, which is very different than diversification. And I believe that when you pile on things that are almost 100% correlated with one another, you haven't further diversified anything. You've just added on more volume of the same thing you already owned, which is different than achieving a benefit of diversification. So I thought a little investment finance vocabulary today and attaching some of these things to concepts

might be useful. Diversification exists so that you avoid the risk of all eggs in one basket. And let's say we're talking first and foremost about the high level of diversification, which is across asset classes. It's what we would call asset allocation. And this is where you're diversifying a portfolio by owning different categories of assets. And that is different than diversification within a given asset class. So let's take the asset class of U.S. equity. For us, we are dividend growth investors. Why do we own, let's call it 30 stocks

instead of 500? Because I don't get any diversification benefit by owning 50, 60, 70. 30 diversifies. 50, 60, 70 is more than enough, and 500 is absurd. And we want to stay within our philosophy of dividend growing companies that we believe in the sustainability of their dividend and all the attractive elements of the underlying business. So 30 happens to be the number. It is an acceptable number to get diversification benefit, but not an excessive number where we dilute the value proposition of dividend growth names. Now, what are the things we're diversifying away from? You say, well, the whole market going down.

Well, if the whole market goes down, you expect that 500 names will go down. By definition, the S&P 500 went down because the whole market went down. But if you own 70 or you own 30, you can't diversify away market risk. You can't diversify away market risk. You can't diversify away systematic risk when you're talking about diversification within an equity portfolio. But there is something called non-systematic risk, a CEO getting in a car accident, a scandal, some factory or plant that goes down because of a weather issue or unexpected competitor dynamic. There are individual things that could come up that you say, okay, this could

come up with this company, but it may not be something that impacts the entire market. That's why you have diversification. And so if something goes wrong with one of your companies and you own 25 other ones, the diversification really helps insulate some of that portfolio. The risk of being wrong on a given company, but that doesn't do anything about systematic risk, which is total market risk. That brings us back to our first category, which was asset allocation. That's where you're trying to diversify systematic risk. You say, okay, well, I have an equity sleeve and if something were to go on the whole. You say, okay, well, I have an equity sleeve, and if something were to

go on the whole market, I have alternatives, or I have fixed income, or I have real estate. So you have different categories. We happen to be big alternative investors, and we believe that we can achieve a diversification across asset classes, core dividend growth, alternatives are some of our heaviest positions. And then we can achieve diversification within those sleeves in the way that I talked about. A mere volume of positions is not diversification. And it is a conscious decision to favor quantity over conviction. And that's where I think diversification comes in. When in the course of pursuing diversification, you allow quantity to trump conviction.

One can maintain conviction and achieve diversification. achieve diversification. And they can achieve diversification at a portfolio sleeve level with, let's call it the number of names you own an equity portfolio or a bond portfolio, what have you, and then diversification at a high level in the portfolio with asset allocation across different categories of investing. And this is the philosophy we would take, and we'd apply that discipline into our portfolio construction that then favors the things that meet our fundamental requirements that do not get selected based on popularity. In an environment where people pick things like meme stocks, because they're playing a game because of the popularity, because of momentum, because of a kind of bet. Those things can go up. They can go down. That's not the issue. The issue is that they have

forfeited an investment strategy that has fundamentals that are knowable and is connected to a company outlook. It becomes a pure byproduct of chance. And I think our clients expect more from us than that. And in this environment we're in, I don't think you have a lot of people investing in chance consciously, but I think you have a lot of people investing in dynamics that are far more out of their control than they may expect. And yet they believe it to be a bit different than it is. When we see risk mitigation this complacent, and when we see sentiment become this euphoric, we feel quite strongly in the conviction of how we've diversified a portfolio. And that's the

underlying message I'd suggest this week. There's a few other little tidbits in the Dividend Cafe, DividendCafe.com this week. A note about natural gas prices. I definitely think the chart of the week reiterating the inevitability of the 10-year bond yield and nominal GDP growth being connected, that when they get disconnected for various periods It's just a matter of time until those those things converge back together

There's a good explanation of it there. So check out Divenycafe.com if you want to see some of these charts But if you got your fix already from listening or from watching then move move on with your life. Go enjoy your Memorial Day weekend. We'll leave it there. With that said, I do thank you for watching. Thank you for listening. And I certainly thank you for reading The Dividend Cafe. I look forward to being back with you next week for what I hope will be a well-executed, very special edition of Dividend Cafe looking back over the last 50 years. Have a wonderful Memorial Day weekend. Thanks so much. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC,

member FINRA and SIPC, 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 of risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative

of current or future performance and 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 opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice. The Bonser Group and Hightower shall not in any way be 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 are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice.

Clients are urged to consult their tax or legal advisor for any related questions.