The Dividend Cafe - It's Been One Crazy Week in the Markets

Episode Date: August 15, 2019

Topics discussed: Is volatility back? You tell me - here was the market action this week: Down 400 points Monday, Up 400 points Tuesday. Down 800 points Wednesday. And as I submit this for the week, Thursday (late morning) we are up a little over 100 points (but saw the pre-market futures up and down hundreds of points at a time). There is always one reason for "up & down" volatility (is there any other kind?), and it is uncertainty. In the Dividend Cafe this week we are going to look at the sources of the uncertainty and seek to enhance your understanding of the world affairs that are driving capital markets at present. This has been the most volatile week of the year in the market, with last week being the second most. In other words, since July 31 we really been sitting at non-stop market drama. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. week of the year. And I'm doing so. Let's see, what time is it? It's midday. Markets have been about halfway through a cycle of Thursday. And the market's up a little over 100 points as I'm talking. So by the end of the day today, I don't know if we're going to give that up, go down 300, go up another 300. I don't know. On Friday, I will say this, the odds are it will do something like that. I wouldn't be surprised at all if we're up 300 from here or down 500 from here or something crazy like that tomorrow as well. That needs to be the expectation. That needs to be the assumption that for the time being, we're highly susceptible to seven or eight out of every 10 days having two, three, 400 point up and down movements.

That's what happens now. That's what's happened in February 2018, in October of 2018, in December of 2018, in May of 2019, and now here in August of 2019. In the last couple of years, when we entered periods of sort of market disarray, the daily expectation was for triple digit up and down volatility. And that's the kind of environment we're in now. It has got to be one of the longest dividend cafes I've ever written, partially because I spent six hours on an airplane yesterday writing, partially because I already had a lot of material coming in partially because i got up at the crack of dawn this morning and wrote another

couple of pages and then primarily because of the market environment we're in i wrote a lot this week in dividend cafe because i had a lot to say okay so i want to say some of it to you now and i want to invite you to reach out to me with other questions or comments bottom line dow dropped 400 points monday of this week it went up 400 points tuesday it dropped 800 wednesday which was the biggest down day in terms of points on the year uh and then this morning at 3 45 eastern time futures are pointing to about almost 200 points up. By 6 o'clock a.m. Eastern Time, futures are pointing to 200 down. It bounced all around. And then now we sit here with the market open halfway through the market trading day, up over 100 points.

So 3, 4, 500 points of pre-market and after-market volatility intraday. You get the idea. We already talked last week about what last week's volatility was. This started on July 31. We went into the renewal. Let's call it round four of the trade war. Things haven't settled since. But now, we're not just talking trade war.

We're not just talking currency war. We're not just talking currency war. We are now talking the impact of a yield curve that's inverted, the threat of recession, the growing reality of global economic conditions that have weakened, and the fears and vulnerabilities around where the U.S. economy is through all of this. As far as the U.S.-China trade saga, nothing has particularly changed. The U.S. said, OK, we're going to hang tight on the September acceleration of 10% tariffs, and maybe we'll sit on that until December. And the president explicitly stated they wanted to do that to kind of alleviate some of the pressure for U.S. shoppers, Christmas shopping season, which I thought was interesting to state that if you also don't believe that there's any negative impact to the U.S. consumer anyways,

and that China pays the tariffs, I don't know why the timing would matter. But I digress. And I do say that with admittedly a lot of sarcasm, because this is very much something paid by the U.S. consumer, something very much impacting the U.S. producer and very much impacting U.S. economy. But let me say this. It is worth noting in the zigs and zags of the market the dow is prime is down but it has had five days in the last 11 days where it was up three or four hundred points these are not times one wants to be trying to time the way around it they can get their face ripped off an investor can get their face ripped off trying to time around this and and being exposed to the down days and missing the recovery

days. These things are going to stay volatile. And the reason is not just because of the trade war, the trade war exacerbating other underlying volatility source like Brexit uncertainty, volatility source like Brexit uncertainty, which is minor. The Hong Kong issue, which is perhaps not minor. The European banking system is in just total distress. Japan getting ready to raise taxes, oil prices being vulnerable. So you get the idea. There's a lot of uncertainty. And when you throw such a major economic event on top of uncertainty, you get this kind of volatility. So what does this mean as far as markets? Does it mean to be in them at a higher level? I don't think so. But there might be particular positions. We've been selective buyers of certain securities this week that we thought reached a level that provoked us to add more to our positions. But does this mean that we want to

be lowering exposure to assets? If one's financial plan has not changed and their allocation was set appropriately beforehand, my suspicion is that right now is not a time to be re-risking or de-risking, but rather to allow the portfolio allocation to do its job, which is to buffer a good portion of the downside volatility and yet still be exposed to the upside and the fundamentals of where we get our return on capital. So the yield curve inverting. Are we going into recession? A lot of my Dividend Cafe writing this week centers on that subject.

And I will say this. Seven of the last seven recessions, the two-year, 10-year yield curve inverted before it did sometime between 12 and 24 months later. It's not really a lot of specificity, in case you can't tell. I believe it is 12 out of 15 of the last 15 recessions, 12 times. So as you go a little further back, excuse me, it's nine of the last 12, the predictive benefit is diluted somewhat.

In other words, there were three times that the two-year, 10-year Treasury did invert and it did not mean a recession. And so you want to be careful, but this time it's different. I'm not going to say it. I just want to make a recession. And so you want to be careful, but this time it's different. I don't, I'm not going to say it. I just want to make a point. The cost of capital is still much below the return on invested capital. Credit use is not declining. And that's generally where recessions come from is a decline in credit use because you have a drying out of credit and liquidity, out of an inversion of the cost of capital and return on capital.

We're not in that environment now. The yield curve is right now inverting out of central bank imaginations worldwide. Global yields on the long term coming down because of excessive government debt and so forth and so on. So I do not want to say this means that it's worthless as an indicator because it isn't. And seven out of seven and nine out of 12, those are compelling historical markers. I am taking it as a sign that a recession will come. And just like in the past, with no ability to necessarily time that. In other words, if the recession is two years away, two and a half years away, this isn't very helpful for us.

Six, nine, 12 months, that's shorter term. I just think that it is actually an unhelpful indicator for short-term market positioning. It's an additive component to market volatility. $15 trillion of bonds worldwide were trading at negative yields before this week. That alone should be a cause of volatility. That happened before this yield curve inverted. That's been going on because central banks are creating bonds ex nihilo, affording governments the ability to borrow more money and to borrow money necessary to fund deficits, to fund a spending level that has

never been thought possible. Central banks have to aid and abet what governments around the world are doing. That's the reality. It's not a political statement, by the way. It's an economic statement. It's a mathematical statement. So I can't forecast an imminent recession, and I certainly can't forecast a lack of one. I fear that reduced capex will quicken the time

that the next U.S. economic recession comes. And I think that right now is probably the best case scenario, that there's a delay. brought about by this trade war over the last 18 months has made a recession inevitable, whether that be in one year or three years, two and a half years, and what could have very well been a three to five year extension of the economic cycle. I am going to do this. I have written about a lot of this stuff at greatlengthanddividendcafe.com this week

and I want more and more for the podcast to be a place people can get all of our thinking and material but I think that this warrants a whole separate podcast to talk about debt the inverted yield curve

and what it means going forward so I'm going to do a whole separate talk about those different going forward so I'm gonna do a whole separate talk about those different subjects so that I'm not rushed I'm gonna encourage you to go to dividend cafe calm this week there's multiple charts showing where bond yields are what has caused the last batch of them the difficulty that I think bond managers now are going to have, because if they've been really biased towards duration, interest rates have dropped so much, they've made a lot of free money.

If they've been biased towards credit, credit spreads had been tightening, they made a lot of free money. You now very likely do not get to see rates drop a ton more, and you don't get to see credit spreads tighten a ton more. And so therefore, how do bond managers add value when the easy work of dropping yields or tightening credit spreads is behind us? It's going to make it very important for prudence and talent at the fixed income management level.

By the way, in emerging markets, I think that the currency unrest, global trade war that seemed to kind of elevate noise, that what we forget is that the developed markets where you see these negative yields, they are struggling, Europe and Japan primarily, because of lack of population growth, lack of productivity growth, secular trends hurting those areas and right now potentially bringing the U.S. down with them. Those trends do not exist in emerging markets. It's very important we remember that population growth and productivity growth

are strengths and advantages and therefore opportunities in emerging markets. The equity risk premium in the S&P 500, the earnings yield of the S&P minus the 10-year bond yield, both because the 10-year bond yields come down so much and the earnings yield is still reasonably high in the market. You now have an insanely high equity risk premium and you have very favorable returns that have come out of owning stocks when equity risk premium has traditionally gotten this high.

Are there factors that could disrupt that historical propensity? Yes, there are. So please reach out with any questions, any comments you may have at this time. We very much want to answer those. And I am going to come back to you with another podcast that we'll probably post on Monday where we really kind of elaborate more of our thinking on bond yields and

on the yield curve and on recession outlook and on the interaction of U.S. markets with global capital markets. But in the meantime, as we sit here in this condition, it is not natural to enjoy it. It's not natural to think to yourself, wow, this is a great opportunity. But I will say that market volatility like this is in fact normal. And despite the seemingly secular headwinds that persist, the fact of the matter is that the volatility, the dividend reinvestment, the wise behaviors that prudent investors will exhibit during this time will work out to our favor.

And along the way, it's imperative that people in my chairs, that me and my partners, make the best decisions we can. And we're prudently and frankly, obsessively working at doing just that. Thank you for listening to the Dividend Cafe. Please reach out with any questions. Forward this podcast to anyone you'd like. We look forward to hearing from you. Thank you for listening to The Dividend Cafe. Financial food for thought.

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