The Dividend Cafe - Learnings, Earnings, and Yearnings

Episode Date: October 20, 2016

Learnings, Earnings, and Yearnings by The Bahnsen Group

Thank you. their phones or tablets or desktops to look at dividendcafe.com just because there are a handful of charts this week that really add to the content and the message of what we're going for. But along the way, let's just kind of get into our normal vocal delivery and we'll encourage you to look at the website later. First and foremost, we want to talk about earnings season that has kicked off here. Q3 results being presented from most companies in the S&P 500 over the next several weeks. Only 90 have released so far. And financials and materials are leading the way. The two very most maligned sectors as of late, and they were expected to perform abysmally, and they've been the great outperformers. The surprise here is in those who are not expecting

this because sectors baking in bad news and then outperforming the lower expectations is as predictable as the very concept of earning surprises themselves. Remember the talk of supply glut? I read a fascinating report this week suggesting that oil shortages will be the story of 2019-2020, not excess supply, as the massive efforts to cap production in the wake of the oil price collapse of 2014 to 2016 will end up suffering a lag effect and leading to a production process unable to meet demand needs within a few years. The Saudi energy minister said this week at the World Energy Congress that over $1 trillion of oil projects have been canceled or delayed since the price drop worldwide. And production capacity cannot be turned on and off like a light bulb. A field producing oil in

2020 likely meant the wheels were put in motion in 2016 or so. Shale, of course, is still the wild card, and how America decides to assert its energy independence will matter a great deal. It's the cash flow, stupid. I actually teach my kids not to say the word stupid, but it is election season, and James Carville's famous dictum from 1992, it's the economy, stupid, was meant to be a generational reminder to politicians always and forever that people vote their pocketbooks. I want investors to always and forever remember that what drives markets is earnings, and we care about earnings to the extent they drive a return of cash to shareholders. We have a chart at Dividend Cafe that tells us all we need to know about the post-crisis rally that we've

seen over the last seven, eight years in stock prices. Did low interest rates help feed growth and then help feed affordability of stock buybacks and dividend growth? Of course. But fundamentally, if you see the chart of how stock prices have moved up, you'll see a perfect coinciding with dividend growth and return of cash through stock buybacks. As earnings go, so go stock prices. Earnings are the mother's milk of stocks. Be careful what you don't wish for. There's more effort in my business to control volatility than almost anything else. And very seldom do we hear from clients that they're afraid of actual loss. When we dive deep enough, we almost always find that client concerns are about temporary volatility. Human psychology

and emotion are reasonably immutable, so we get it. But take a, well, I can't say take a look. Rather, understand that volatility intra-year is the norm. It's a given. It's an inevitable part of investing, the rule, not the exception. So rather than me telling you listening to this to take a look when you're in the course of listening to a podcast, I'll just tell you that if you go to Dividend Cafe, you're going to see of listening to a podcast, I'll just tell you that if you go to Dividend Cafe, you're going to see a chart that shows you the upside and downside move year by year by year for the last 35 years. And what you'll see is big swings each and every year in stock prices. However, the results for those that have maintained a defensible and disciplined strategy through

the thick and thin of volatility have been stellar. Bottom line is stocks have been up in 77% of the roughly last 100 years, down in 23% of those years. And in the down years, the average down year is roughly 14%. That volatility has been the price an equity investor is paid for equity-like returns. Intra-year volatility is even more benign. To compress the volatility is to compress the return premium. You get my point. But lest we forget, by the way, the same volatility is not something stock investors take on, but bond investors get to skip. The 10-year bond yield on a 10-year United States Treasury was 15% in 1981, 35 years

ago. It's just over 1.5% now. A bond bull market for the ages, a 35-year period of interest rates dropping 90%. But even in the midst of a 35-year move down for bond yields, in 13 of those years, one-third of them, the yield was higher year over year, meaning bond prices were lower. So you had to have a negative return more often in bonds than stocks over this generation and yet you took on that greater negative volatility for the return target of bonds, not stocks. What is sauce for stocks is sauce for bonds too.

You haven't gone crazy. People do indeed borrow more money when it costs less. One of the most questionable assertions many have made in the last few years is that a low cost of money does not necessarily correlate to higher or borrowing. It's not only a bit silly intuitively, but empirically as well. We have a chart at Dividend Cafe showing how the lower interest rates at which debt was available translated into an increase in total debt levels, even as the expense of the interest did not grow so dramatically, you know, because of the lower rates, obviously. There's room for debate over whether or not this is a healthy development, but there is not room as to whether or not it actually happened. but there is not room as to whether or not it actually happened. Debt levels are higher, and with it, to a less modest degree, the money being spent on interest expense. One of the big themes entering 2016 for us at the Bonson Group was old tech names where there was a value in their price and dividend growth being a better play than NewTek, where despite the

hipness of the names, high valuations had run amok. Please check out our written commentary this week for a chart showing exactly how that has played out. I'm going to spare you the details of our kind of deeper dive that we do on the website regarding the weakness of the dollar relative to the yen this year. The nutshell of it is just simply that the Japanese yen currency has risen 14% against the U.S. dollar, and yet the Japanese central bank is doing everything they possibly can to weaken the yen. The point we make is that the impotence of central banks right now has been really demonstrated through what's happened in Japan this year. Well, if it's not door A, is it door B? When I say monetary authorities are largely out of bullets to effectuate economic activity and

progress, does that mean I'm advocating for fiscal activity to spur economic growth, like Keynesian government spending? What we know is this. Government spending increased about 4.5% per year for 25 years going into the 2008 crisis. Coming out of the crisis, the Keynesian remedy was a stunning 23% increase in government outlays, that 228, 209. The results are well known. GDP growth has been less than 2% for years now. Whatever growth that government spending created was front-loaded and simply pulled into the present growth from the future. Worse, it crowded out private market activity, which impeded overall organic growth all the more. And, of course, it added untold trillions to the national debt. So, I'm saying door A, monetary manipulation, and door B, Keynesian stimulus, are both now busts.

If only we had a model for real organic dynamic growth, such as, I don't know, JFKs and Ronald Reagan's supply-side tax cuts. for rethinking the very act of thinking. Where hedge funds and alternative investments have failed to add alpha into a portfolio return over a sustained or legitimate period of time, they failed in their role as a portfolio strategy. By alpha, we mean an investment return in excess of what normal asset class returns could be adjusted for the beta, the market risk and correlation. It behooves portfolio managers like us to incorporate alternatives where beta, market risk and correlation, will be very, very low so as to maximize their benefit as diversifiers. And then from there, manager skill needs to create the excess return, the alpha, at least through time.

Hedge funds have had a tough go of things in the last year, at least many of them have, certainly not all, but any further look shows that as the timelines expanded, the alpha benefits and the diversifying non-correlation benefits of hedge funds grows. Fees are often blamed for hedge fund problems, but of course fees are lower now than ever and hedge fund outperformance was highest in the period where fees were highest. Ultimately the answer is in these two realities. When beta is doing just fine, broad stock market exposures, no one feels the need for correlation. So the thesis for hedge funds gets undermined and yet the very point of

alternative investing is for when markets are not doing all the heavy lifting. And then number two, not all hedge funds are created equal. There are different managers, different strategies, executing different viewpoints in different asset classes at different points in time. Broad brush painting doesn't work here. I'll close you with the quote of the week from Sir Winston Churchill. However beautiful the strategy, you should occasionally look at the results. That wasn't necessarily meant to be an investment-themed quote, but of course it has great application in the investment world as well we're very focused on strategy we're very focused on results of the bonson group we hope you have a wonderful weekend we look forward

to our podcast next week and encourage you again to check out the website thanks so much