The Dividend Cafe - Earnings and Elections Cap a Huge July - July 29, 2016

Episode Date: July 28, 2016

Earnings and Elections Cap a Huge July - July 29, 2016 by The Bahnsen Group

Dear valued clients and friends, welcome to this week's Dividend Cafe podcast. The month of July is now behind us and we enter August next week, which actually represented the worst month of 2015. I do loathe superstitious calendar correlations posing as real market analysis, but I certainly have not forgotten the serious challenges that August of last year represented. We were coming out of a Greek drama and then we entered a China one, for those who don't remember. Well, this week we're going to review the July that just was and talk a bit about August and beyond. There's a lot to it, so let's get into it.

There's a lot to it, so let's get into it. In our executive summary, a few quick points to kind of recap for you. Number one, July is set to end as another strong month for equities, although it was a weak one for oil prices. The issue with oil is the U.S. dollar and how oil dropped as the dollar rallied earlier in the month, but it did not move higher as the dollar sold off this week. Number two, the stock market's performance in an election year impacts the election a lot. The election doesn't generally impact the market. Number three, emerging markets have really turned for the better and present great growth opportunities for the future, but are vulnerable to external shocks, particularly if any central bank decides to become tighter than expected.

And the currency matters. Number four, the disconnect between global GDP growth's trend line and the actual GDP growth of the last decade is the source of a lot of political angst. In the news this week, the Democratic Party officially nominated Hillary Clinton as their party's candidate for president, and the DNC convention finished up in Philadelphia on Thursday evening. The Federal Reserve announced on Wednesday that they were keeping interest rates flat yet again, basically stayed status quo in their outlook. In our core summary, China, the corporate profits have been much stronger than expected this year. The consumer sector has gradually grown a bit,

but their industrial sector is really the issue there, rapidly growing in response to that housing boom. It bodes well for 2016, but it does not bode well for 2017. Oil, if I only had one thing to watch in formatting my views around oil, it would be the U.S. dollar. Ultimately, it's supply and demand, always and forever, that drive oil prices. But supply and demand metrics are highly dynamic, volatile, unpredictable, and with OPEC, they're often unreliable. To the extent that oil is a global commodity denominated in the U.S. dollar, this correlation is hard to break. And by correlation, I mean the inverse of the dollar being highly correlated to oil prices. In our dividendcafe.com article we have a fascinating chart that shows you how strongly correlated oil and the inverse of the u.s dollar are and how that correlation has broken apart here in the last

couple of months um so july was interesting for oil because the dollar did strengthen against the yen and euro, which of course are the two most dominant currencies in the world besides the dollar, but it depreciated, the dollar depreciated against many emerging market currencies. So that whole story regarding the dollar and oil, their relationship to one another, it remains in flux, but we think it's very important. In terms of recession watch, the economy, you know, obviously was not strong enough to get the Fed to raise rates even a quarter of a point. But they did say in the report this week that, and I quote, near-term risks to the economic outlook have diminished. So there you go, the muddle through economy continues.

On the earnings front, with essentially half of the S&P 500 having reported its Q2 earnings results, 74% have beaten their earnings projections and 52% have beaten their top line revenue projections. The strongest surprises have more or less been in the financial sector. On the election front, we'll double up on our two E's today in core. The Democrats hosted their convention in Philadelphia and suffered a lot of the same commotion and then some that the GOP experienced last week. The satisfaction with both candidates in both parties is very low. It feels more like a protest election year, an anti-establishment year, than any election I've studied.

Of course, though, Huey Long and William Jennings Bryant are not going to become president. They didn't become president before. But the point is, in a year like this, prognosticators are wise to respect the uncertainty of things. And we have a chart in thedividendcafe.com that starts at 2012 and goes backwards. But again, saying that the stock market reasonably predicted the election 19 of the last 22 times. We're taking a look at that. A reader asked this week, do we want our currency to go up or down to help the value of our investments? I'm confused. I assure you you're not as confused by this as the

media is. I mean, yes, it definitely can be a confusing situation for everyone. It's important to understand though. When you use U.S. dollars to buy a foreign investment, like a stock in Europe or a stock in India, the return on that investment will be the amount the investment goes up or down, plus the amount the currency of that country goes up or down. So if an emerging market stock is up 5% but the currency of that country is down 5% relative to the dollar which we'd be converting back into, when we sell that investment we'll have a 0% return, a plus 5 and then a minus five equaling zero. So the more a foreign investment sees its currency go up versus the currency we brought from or convert back into, the higher

the return will be. If one believes the investment is good but the currency bad, they generally may want to hedge out that currency risk. There's certain ETFs that do just that. But the reality is that over the years, a lot of the return of overseas markets has involved currency appreciation. It's incumbent upon investment managers like us to take these things into account in our decision-making process. What is it economically that has made this year such a tense and angst-filled year for voters? One client asked, referring probably to the Trump nomination, to the Brexit and the other side of the pond, things like that. My friends at Strategist Research have a very plausible theory, and I provide a chart for it at DividendCafe.com, theory and I provide a chart for it at dividendcafe.com, basically showing that the trend line of GDP growth is, GDP is off of its trend line. There is a gap and we have been, you know,

expecting something in between three and three and a half percent net of inflation, real GDP growth for many, many years. And that has, that number has come down. And that gap in dollar terms represents over $6 trillion, $6 trillion of less economic growth than we are used to achieving. I think that that is a very plausible explanation that has led to a lot of ramifications that then creates a lot of voter angst. The real problem with an artificially easy monetary policy, lower interest rates that are appropriate given a certain level of economy, but then go even lower than that, more money supply creation than economic growth warrants, etc.

The problem is the malinvestment it creates. Monetary distortions cause a distortion of risk, and that creates decisions that otherwise would not and should not be made. Case in point is that there has been $450 billion of corporate debt issued this year alone, not even counting high yield, the very poor credit. not even counting high yield, the very poor credit. Of that $450 billion of investment-grade credit, which is supposed to be the higher quality, low default risk bond ratings, 44% of it, almost half, is now BBB rated, and so the lowest rating of the technically above line ratings. That number was 10%, you know, 25, 30 years ago. So BBB is still in the good quality classification barely, but we have a few hundred billion of bonds right now on the knife's edge of becoming junk status. It's a direct result of a borrowing binge and capability brought on by the artificially low interest rate environment.

The danger is in trying to forecast exactly how this will play out, but there isn't a lot of danger in forecasting that one way or the other it will not end well. The weekly reinforcement of a permanent principle, properly diversified investment strategies that have expected rates of return which surpass the safe rate, like a short-term treasury or something, those types of investments will have volatility. In fact, the expectation for a rate of return higher than the safe rate is a byproduct of that volatility. But to confuse volatility with risk is a cardinal error. It results in all kinds of investment mistakes. We aim to manage client assets to avoid the

permanent erosion of capital. We even manage client assets to somewhat limit volatility for obvious emotional, psychological reasons. But we do not manage client assets to eliminate volatility because to do so would mean eliminating the possibility of a return. The bull in us this week wants to say that it is, you know, we recognize it's risky to come out in favor of emerging markets equity right now. A significant amount of pundits believe that emerging markets is very vulnerable in a global growth slowdown and also vulnerable to U.S. dollar strength. But the space itself, you know, has already rallied 28% from the January bottom, which makes it even riskier to be advocating it now. But we see significant increase in smart money entering the emerging markets. And we think a lot of people believe that the central bank will be more accommodative,

not tighten just because of Japan and Europe and things like that. So there's certainly external shock risk, but the fundamentals in emerging markets, given the backdrop we presently have, are attractive when we factor in the risk. The whole space is risky, but there remains strong commodity price dependency throughout many emerging market companies, and the earnings on an index level can be volatile. So we're bullish on the backdrop of the whole emerging market space, but then we execute it within our own company selection philosophy differently. What's based on earnings growth is based on dividend payment,

and it's based on the pricing power of those companies that we're buying. The bear in us this week is really having a hard time understanding why more attention is being put on this situation, is not being put on the situation with Italy. There's little dispute that the banks are on the verge of insolvency. We see no option that doesn't carry profound spillover possibilities. Italy conducting a domestic bailout would certainly mean massive debt levels at ratios on par with Greece. But then if the European Central Bank steps in, which is what we presume would happen, does a precedent get set for other countries? This reality and the political uncertainty around the October referendum all point to a substantial risk in Italy and Italy's direct touch points like

the European Union for the next several months. Please go to our website at thebonsongroup.com and check out our financial concierge services tab. We think there's a lot of information about the family office services we provide we want you to take advantage of. And check out the chart of S&P 500 dividend growth per share at DividendCafe.com. It will make you extremely excited for a portfolio that is concentrated into only the best dividend names that can be found at DividendCafe.com. I'll leave you with this. The biggest business in America is not steel, autos, or television.

It is the manufacturing, refinement, and distribution of anxiety. And we serve at the Bonson Group to alleviate that anxiety, to buffer the anxiety that the media does often manufacture and distribute. And we hope that that will be a value to you. We wish you a very good weekend. Look forward to bringing in August with you next week.