The Dividend Cafe - Farewell October: Markets, MidTerms, and Trade Wars

Episode Date: November 2, 2018

Topics discussed: Trade War Turmoil Earnings, or Price-to-Earnings? Capex alert - or, How Is the Economy? Links mentioned in this episode: TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe. I am recording this podcast on Thursday morning and the market has just opened as we begin the month of November and we're actually up so far here Thursday morning a little over 100 points on the Dow and this comes after a 673 point move up in the Dow on Tuesday and Wednesday of this week uh the so the market is comfortably up on the week it had been down a few hundred points Monday Monday was fascinating because we were up a few hundred and then went down a few hundred points Monday. Monday was fascinating because we were up a few hundred and then went down a few hundred. And so the gravity of the swing from high to low,

you actually had something like a 700-point intraday swing after new talks about tariffs, believe it or not, and threats to impose another batch of tariffs on the remaining $267 billion of imports coming in to the U.S. from China. And that was talked about as something to potentially be done in December, which would be after the midterms, but also after the president's meeting in China later in November. Excuse me, the meeting is not in China, but with Chinese leadership and so forth.

And so anyways, my point being the tariff issue continues to weigh on market volatility. And this comes off of one of the most volatile months for the market in a long, long time, and certainly one of the worst performing months for the market. The Dow was down 1,700 points from its high level. This is not for the whole month because we were up in the first couple days of the month. But from our closing high, which was the all-time high in the Dow October 3rd, we were at 26,828 and we closed 1,700 points lower than that, which was 6.3% by the end of the month. The S&P was down 7.3% from that same high point. And then the NASDAQ was down 9%. So you had the worst month for the

Dow and S&P since September of 2011. And you had the worst month for the NASDAQ since October 2008. Nasty month for equity markets all around. And of course, we've been unpacking that throughout the entire period. Awful lot of writing and commentary and analysis and different podcasts and videos to try to give you information on what's going on and why. But there's more to say this week. So let me get on into it. Trade war turmoil. Well, like I mentioned a moment ago, the evidence I see is more and more pointing out the direct consequences and second and third derivative consequences of the present trade war being in the middle of much of what is plaguing markets. I've laid it out over the last couple of weeks.

U.S. markets have essentially faced downward pressure on valuation. I'm going to talk more about that in a moment. As investors weigh the realities of vulnerable global conditions in the context of a normalizing U.S. monetary policy. At the heart of these global conditions is the impact of the trade war. And investors clearly are seeing how that impact is not limited to the counterparty countries. You know, you have China obviously being the most important one there, but the fact of the matter is that there's been a tremendous impact to not just China, but to the United States as well.

And so that big reversal we had on Monday coming after the announcement that if these meetings with Xi Jinping of China do not go well at the end of November, we may end up seeing even more tariffs implemented. It's not easy for individuals. It's not easy for markets to separate bluster from policy. But the point being the trade war headwind is significantly offsetting a U.S. market that is filled with tailwinds. Now, in terms of that U.S. market, I have a chart at DividendCafe.com this week that I think is incredibly useful at laying out the real story of what's going on. And it shows you five years in a row of what the dividend level has been in the S&P, what earnings per share have been, and what the total return has been, but then the P.E. multiple, the price to earnings,

the amount investors are willing to pay for a given level of earnings. And it gives you a chance to see how much P.E PE expansion has contributed to the market's total return in each of the last five years and how much earnings themselves have contributed. And what you see is that in 2017, for example, you got significant earnings growth in the market of roughly 12%. And then you got about 8% earnings expansion, price to earnings expansion, the multiple. So there you get your 20% or so return. You tap on dividends and there you are. Well, what you see this year is that the dividends are about the same and the earnings are higher. The earnings growth year over year is closer to 19%. But the market's flat on the year. How's that possible? Because

the price to earnings ratio has dropped about 20%. So you get the valuation as the key impact to markets. And you got to see it visually to really pull it all in but it is i think an incredible story um that needs to be better understood and i will argue that dividend growth is is particularly when you're isolating your portfolio around companies that are focused only on dividend growth it not not only is moving forward, but it kind of insulates out a lot of the downside volatility in pricing because the tension of those wild price movements becomes somewhat immaterial to the focus of what you're generating your positive return from. And so it's a concept that is most understood in a period like this when people believe, for stupefying reasons, that they can generate investment policy out of accurately predicting when P-E ratios are going to expand and not. Now, my bull market thesis for extension of a few innings of the bull market we've been in has long been predicated on the idea that we need a business investment renaissance driven by capital expenditures that will help enhance and drive

greater productivity. And out of that greater productivity, enable a new dimension of corporate profitability that creates its own virtuous cycle and is part of its own virtuous cycle and gives that not only economic boom, but investor and market response as well. And I have to say that the Q3 GDP number was very concerning in this regard, because even though we got a 3.5% real GDP growth rate, which was stronger than the 3.3 or 3.4 people were expecting, and puts us pretty well on track to ensure that we'll end up with that over 3% real print for 2018. The fact of matter is that within the formula for how gdp is calculated the investment section non-residential fixed investment in the economy and the private sector was only up 0.8 percent

quarter over quarter and we had had huge numbers in that regard in q1 and q2 and yet core capital goods orders were flat in September. And I believe fear of the trade war and tariffs is behind that muted activity. In fact, trade subtracted 1.8% from GDP in Q3, largely as people were working to get in front of the fear of tariffs. You know, if you just sort of normalized for what the average trade impact has been over three years, it would have subtracted 0.3%. And yet it subtracted 1.5,

well, excuse me, 1.8 this time. So a net difference of 1.5, and that's with a 3.5% real GDP growth. So, you know, you can do the math. We would have had about a 5% GDP number if we had normalized trade conditions. So the need for ongoing business investment is the story on which the continuance of this bull market will sink or swim. And right now, it's an unforced voluntary policy decision that is holding that business investment back. I mean, I don't have much doubt, frankly, that lowering the cost of capital,

which the tax cuts did, increases capital spending. And I have no doubt at all that increased capital spending and business investment drives productivity and therefore profits. But the question is whether or not the trade war fear overhang offsets the supply side benefits of tax reform. I have far less doubt about whether or not CapEx will lead to what I've projected than I do whether or not said CapEx itself will materialize. I'm not throwing in the towel by any means, but this quarter's tepid business investment is a disappointment

and evidence that the global trade and tariff nerves that exist are suppressing it. Quick earnings report card, then we got to wrap it up. 67% of companies have reported earnings so far and 77% have beaten their quarterly profit expectations. 59% have beaten top line revenue expectations. Q3 profits appear headed towards a 22.5% year over year profit growth, the highest in eight years. That's all stunningly good news. The bad news is that stock prices have had their worst response to positive earnings surprises in years. The S&P 500 is now down to a 15.5 times PE ratio

on its next 12 month of earnings, which compares to a 16.5 five-year average. We started the year to 18.3 multiples, so just incredible. Earnings have grown that much, but the multiple has come back that much. Definitely go to DividendCafe.com this week to look at a handful of different charts that obviously can't make their way into the podcast. So I'm going to leave it there, though, just in the interest of time and now kind of getting into market combat. Reach out with any questions. I'm going to try to do a little recap of October in our weekly portfolio holdings report next week. But there's a lot to talk about, a lot going on. I want to answer any and all questions you may have. And we're going to keep doing what we're doing.

Reach out if we can be of any assistance. And most importantly, thank you for listening. Thank you, clients, for your ongoing trust, confidence, faith in what we're doing. I would love any of you podcast listeners, clients, or otherwise to give us a little review there on iTunes. Subscribe to the podcast so that it shows up as a subscriber, whether it's Google Play or Stitcher or iTunes, whatever you're doing. And certainly forward it around to your friend as we try to increase this podcast traffic. Okay. I think that's all I have to say for now. Thank you for listening to this week's 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, Financial food for thought. the investment process or the investment opportunities reference herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee.

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