The Dividend Cafe - God Grant Me The Serenity

Episode Date: December 14, 2018

Topics discussed: Working only on the things you CAN control P/E Ratios and Stocks going Down A Diatribe of Dislocations Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. this week's podcast, but the problem is I have a lot to go through, and so I kind of got to jump right into it. As I'm sitting here recording, markets are up a bit on the week, about, I don't know, 150, probably 200 points. Nothing super constructive after last week's downside. And of course, whatever I'm saying right now could be ancient history by the time you're listening. You know, it's funny, the market might appear that it's been quite non-volatile this week because the up and down movements day by day look to be really small. We were up 30 and down 50 and things like that. But the intraday movement has actually been really surreal. I mean, we were up 600 points off of the low on Monday. We were down 400 points from the high on Tuesday. So it's been pretty action-packed, but it's been more intraday as opposed to closing moments.

And it's a testimony to the folly of this media and digital age that we're even talking about one minute, one hour, one day, one week, and, yeah, for that matter, one-month periods, particularly as it pertains to capital that has 10-year, 20-year, 40-year timelines and the objectives. But here we are. The short-termism of the culture is powerful and had no reason to be limited in its touch so as to not affect investors. What I'm going to do in this podcast this week is address some of these things. I'm going to kind of lay out for you a longer view of how we want to approach the various categories by which an investment manager tackles markets. And I do a longer form unpacking of that subject in our Dividend Cafe video this week at our YouTube channel. But the podcast is also going to jump into Europe a little. You got a lot of drama

going on over there. Brexit. We're going to talk about the trade war, talk about politics, the Mueller investigation, you know, a lot of fun stuff. So stick with it. But hey, just by me saying the Mueller investigation, maybe I've now teased you into listening all the way to the end of the podcast. That seems to be the IQ of our pop news culture right now. But no, I think you'll end up disappointed if you're only listening for that stuff. Okay, listen, there's a famous prayer called the Serenity Prayer. It talks about the ability and the wisdom to know what can be changed versus that which cannot. It's been my thesis for many years that there are effectively three major categories of the way that investment managers tackle markets.

One is for an investment manager to close their eyes and view all aspects of that which affects their client holdings as unmanageable, uncontrollable, therefore calling for a completely passive and hopeful approach. You could sort of consider this an extreme passive option. The second one is to believe hope against hope in defiance of the experience and exhortation of the smartest investors in world history that all aspects can be foreseen, known, avoided, predicted, anticipated, acted upon. PE ratios are about to contract? No problem. This person will know.

Geopolitics about to intervene in market sentiment for a week? Yeah, no worries. This guy will get in front of it. Central banks about to relax monetary tightening? Well, this person knows exactly what they're going to do, et cetera, et cetera. In other words, this approach seeks to not just monitor what's effectively manageable, but that which is definitely not manageable, knowable, or controllable. And then the third option, and in case you can't tell, this is going to be the one that we take very, very seriously in our approach and philosophy of investing, is to focus one's active management on the limited scope of what can be researched, is evidence-based, and fits within the framework of risk-reward calculations.

This is a more humble approach than option two, and it's a more industrious approach than option one. It also happens to be the heart of our philosophy at the Bonson Group. So managing and monitoring the free cash flow growth, the dividend payout policies, capital allocation on the balance sheet, the nuances of a company's income statement, the culture of a company, the alignment of management with shareholders, the cyclicality of an earning stream. These things are reasonably manageable if one is willing to invest the time and effort into such a process. It's the laziness of option one and the arrogance of option two, not to mention the futility of it, that cause us to reject those two

options. Those who experience temporal success in option two fall prey over and over over again to the most dangerous investment trap on the planet and that is being fooled by false noise, being fooled by randomness, mistaking happenstance for repeatable skill. It's a systemic problem. Even in option three, the focus on that which we believe can be studied, dividend growth is an example versus what cannot be known, the direction of PE ratios, for example, also requires what I might call a constrained vision of investing, meaning the hope or belief that it even can be done perfectly or without error is tragic and wholly unnecessary. Risk management can avert the

problems that arise out of analytical mistakes. The free gift of diversification and asset allocation go a long way. A constrained vision combined with a focus on that which can be managed intelligently makes for a much higher serenity in the investing process and investing outcomes than any alternative I've ever seen. Hey, speaking of PE ratios, interestingly, the bears love to appeal to the high PE ratio of the S&P 500 in 2016, 2017 to make their case for stocks going down. And stocks went from 16,000 Dow to 26,000 Dow, by the way.

But, you know, just a little 60% gain from trough to peak in those two years. But an interesting thing happened for those people who got their faces ripped off with that pathological permanent bearishness. And that is that the forward multiple, the PE ratio of global equities is now the lowest it's been in five years. The combination of lower global equity prices bringing the multiple down and then earnings themselves substantially rising is made for a PE ratio at multi-year lows. Has this caused these valuation fearful bears to change their tune? Of course not. Perma bearishness is a pseudo-intellectual sociological deficiency, not a rationally driven exercise in analysis or objectivity.

It's all about business confidence. I need you to go to marketepicarian.com or go to our Advice and Insights podcast for the week, where I lay out a much more elaborate connecting of dots from how this post-crisis economic recovery needs enhanced profits to drive markets higher, and enhanced profits need greater productivity in the face of higher input cost, how higher productivity needs increased business investment via capital expenditures, and how higher CapEx must come from greater business confidence, and how an undermining of business confidence due to the trade war has therefore been at the heart of this market sell-off. Market at pekirian.com

and our Advice and Insights podcast. How does one know if a market correction is a dislocation or a secular reversal in markets? Of the 60 plus times that markets have experienced a 5% plus dislocation over the last nine years, even as markets have advanced 300%, how did we know each time that it was a temporal dislocation and not a lasting reversal? Well, let me say this. Can you imagine someone in my shoes saying that they did know when dislocations were happening and how long they were going to last? I mean, heaven help us. The answer is that embedded in the risk premium of markets is that you do not know how long dislocations last. What we have to do as market fundamentalists when such dislocations take place is look at the causation and determine

how much a price movement is sentiment-driven relative to fundamentals in the causation. We have to evaluate how transitory the catalyst of dislocation may be, and we have to do risk-reward calculations, period. Now, with that said, there are clear potentially transitory catalysts in the recent market sell-off, meaning trade uncertainty that may very well get better. It could very well be transitory. I think it will be. But that potential for a longer period of trade-induced distress is real. And the uncertainty around the current state of affairs is presently real, not merely potential. So I feel very comfortable calling this current distress a dislocation, and I would add it's a self-induced one, a policy-driven one.

But I also feel very comfortable advising my clients to stay prudent and judicious versus reactive and rash. Good investors have an investment policy that drives their investment practices. Otherwise, they're winging it. We have a custom investment policy written for every single individual client of ours. A lot of you may not know that. That policy reflects a target or a bandwidth of comfort around downside volatility. That targeted downside is not meant to be theoretical.

It's a real number of real comfort around potentially real volatility. So when markets decline a fraction of that downside tolerance figure, they have not violated investor strategy. They're very much within the strategy and with room to go. Hey, let's unpack real quickly for you the jobs report. Last week, the November number was expected to be closer to 200,000 new jobs created. It came through about 155,000, so the unemployment rate stayed at 3.7 percent. And we've seen for some time now that we need to roll at quarterly averages of these numbers

to get a kind of proper evaluation of the jobs data. It smooths for lumpiness that comes through in the data. On the trade war front, the trade deficit increased to $55.5 billion in October. And that does impact GDP because GDP reflects exports minus imports in its formula. But the total gross amount of trade was higher, which was quite encouraging to me. Look, I've talked a lot about trade deficits in the past. There's a link in dividendcafe.com this week to one of our pieces I wrote earlier in the year on the subject. Fundamentally, we know trade deficits are not good or bad in and of themselves. The key is in other circumstances around what's causing the trade deficit.

But what did create this expansion of trade deficit was a collapse in US export of soybeans. It made up almost the entire delta between the actual number and the consensus expectation. So our agricultural industry is taking around the chin in this trade war, and we shall see how that improves in the ongoing negotiations. So, you know, you have this drama taking place in Europe. I have a chart at DividendCafe.com this week showing you what I think is really a key metric behind the angst that exists in both France and Italy right now, how the industrial production since the advent of the Euro currency exploded for Germany and has stayed so high, rebounded nicely since the financial crisis.

Yet France and Italy, it is significantly lower than it was when the euro currency came about. That's one economic illustration of the fact that the shared currency has not created shared opportunities and blessings, and they have a real milieu to deal with culturally and economically. We continue to have a significant underweight to European exposure. But then what about Britain? Yeah, the UK-Britain Brexit discussions this week have this kind of air of uncertainty

around them. Prime Minister Theresa May barely survived an attempt, a stripper of power. The parliamentary vote on the Brexit particular still remains pending. They don't have the votes right now. So you have this kind of uncertainty around whether or not you can have a real hard Brexit or you could have no Brexit Brexit. They're trying to get to some place in between. I remain rather certain, or I should say confident, that the real risk is in uncertainty-induced

volatility along the way that the process creates, but that neither a non-Brexit or a brutal Brexit are real scenarios. There are so many things going on in the world right now that are creating market volatility as part of a kind of negotiation process. It's somewhat tiring. It seems fairer than it has in the past to wonder if the various headline events around Michael Cohen, Paul Manafort, Michael Flynn, Rob Mueller, the Southern District of New York are beginning to impact markets. It's been my position for a year and a half now and clearly reinforced by market action that the various dramas around the special counsel have received a shrug from

markets as markets have obviously been more focused on tax reform, corporate profits, the Fed, trade war, et cetera. Nothing's going on that changes that prioritization. The markets will never have the same priorities that the Beltway does, much like Main Street probably will never have the same priorities as the Beltway. But that said, should this kind of legal circus escalate to a certain point for the president, it's entirely possible it would elevate volatility levels in the market. Now, that's different than expecting the market to respond in any little movement around societal

clowns like Michael Cohen or Michael Avenatti or something like that. To the extent any substantive levels pick up, beyond just noise, the vulnerability of the market right now is susceptible to any number of volatility catalysts. But if you ask me to rate what political events matter to the market, I would say it's 20 parts trade war for one part special counsel. As far as that ratio goes, I actually may be understating the relevance of the trade war and overstating the legal drama. And I really do mean that. Yeah, go to DividendCafe.com to see our chart of the week, which shows you the historical

period of time after a yield curve is inverted. By yield curve inverting, I mean when the two-year treasury is yielding more than the 10-year treasury, and how many months it is often taken before a recession came in as a result of such. It was two years after the yield inversion of the mid-2000s before the recession started in 2007-2008. You have 13 months, 18 months, 17 months, 10 months, the last four recessions before that. You had 51 months when you go back to the late 1960s. So I want to just reiterate that point. The yield curve is not inverted yet. I don't know if it will. It's extremely

flat. So it's susceptible from a policy error to inversion. And inversion has always meant a recession to follow, but it just has never meant something that we can time due to the unpredictability of lag between when it happens and when a recession surfaces. I'm going to close it out there. I appreciate you listening to this week's Dividend Cafe podcast. I hope that you will review the podcast, give us some stars, subscribe in your feed to it, forward it to friends and all those different announcements

I make every week that you hate listening to, but are really important to us at the Bonson Group. Reach out to any of our advisors, any questions you have, any comments you want to make. We're here to help

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