The Dividend Cafe - Lessons From the COVID Era - Introducing Operation Magnify

Episode Date: October 2, 2020

I wrote the majority of this week’s Dividend Cafe before the news had broken that President Trump and First Lady Melania had tested positive for COVID. We wish them a speedy recovery, of course, but don’t have much to say about “market implications” of such, other than the obvious – more uncertainty, more volatility. I will hold off on political and market implications for a few days, for obvious reasons. There are lessons from the COVID era that will stick with us forever. Most of them, mind you, if not all, were not new lessons - they were reminders - reaffirmations of timeless lessons and principles. I am not sure the way we were reminded of some of these lessons felt familiar. Markets do not often drop 36% in 31 days. But these general principles all held true, in spades. In this week's very important Dividend Cafe, I am going to write about some of those lessons (not all of them), and transition that into an opportunity to MAGNIFY what we believe at The Bahnsen Group, what we are doing now, and how we are using the COVID moment to optimize client portfolios for the years to come, all by just MAGNIFYING what we have always believed. This Operation Magnify that we have been developing for months is both a proactive and reactive process. We want to take new realities to their logical conclusions and apply them into an investor's portfolio, and we want to create an entirely consistent process and infrastructure by which we assess and administer this on behalf of our clients. If you are not a client of ours, it really doesn't matter. The moment you are living in is a moment of paradigmatic change for investors. Viruses and the risk of viruses have always existed. "Tail risk" events that shock and awe markets have certainly always existed (and always will). But there are fundamental realities that have changed - many of which were well under way pre-COVID, I assure you - and the discussion in Dividend Cafe today is useful even for those not under our care. The same is true of your approach to investing, and that is where we are going in today's Dividend Cafe. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to this week's Dividend Cafe. This is David Bonson. I'm the managing partner here at the Bonson Group. I'm excited about this week's podcast. We have a very exciting project that has now come to fruition that we've been working on for many months at the Bonson

Group and I think is a culmination of a lot of work through this COVID moment. And I want to kind of set a little context as to what has driven this, what we're calling Operation Magnify, what we think the COVID moment has meant and represented, where it fits into all this, and what other circumstances are that ought to drive some thinking about investors' portfolios right now. It's the kind of stuff we talk about every week in Dividend Cafe. It may not seem like it's particularly different, but I think that what we've done is really sort of crystallize a holistic set of questions to be asking, of conclusions to draw, of various kind of turning points in your portfolio considerations.

And a lot of it is out of the COVID moment. And a lot of it, it may seem like it is, but it is somewhat unrelated. But I'm going to unpack all that. So let me jump in with a few observations. Now, you may ask, why are we talking about COVID in the past tense? Because I'll be the first to say COVID is not in the past tense in the sense that there are still a significant amount of cases of coronavirus, both domestically and internationally. There's going to be a lot more cases. There's no reason to act as if COVID doesn't exist anymore. It does. And I'm very sad to say that there will be more people who die from it. We have a ways to go here. But what I'm referring to is in the fact that we stopped our COVID and

markets.com missive this week, Daily Communique around COVID and its impact on markets. And we did that because I did believe and do believe that what needed to be said about it has been said and that a daily regurgitation of redundant data around hospital beds in this state and declining cases in that state and increasing hospitalizations in this state and declining positivity rates in our country or whatever, all this stuff, I think is unhelpful to investors. There are people that may be interested still in kind of following that on a daily basis. I've been following it religiously from a multitude of sources, but I was doing that in my capacity as a professional investment manager. I was not doing it in my capacity of just an interested citizen or someone who wished

they had gone to medical school. I think that the market import of those things is past. And so to me, I'm talking right now about things in our portfolio, what we've learned from the COVID moment with the full appreciation that back in the month of March, 2020, there were events that took place that were unbelievable reaffirmers, reaffirmations, reiterations, reaffirmers, reaffirmations, reiterations, reminders, whatever, very important principles that have been at play for years and years and years for market investors. I do not think they were new events. Now, the circumstances were new.

The exact context was new. A global pandemic like COVID-19 had not been around a long time and the uncertainty in March of what the exposures would be, what the vulnerabilities were, what the fatalities would end up being. Those things were all really unknown as well. I do believe that for all of the talk about where things were going to go with COVID and where they have gone and then cases that kind of went down but then came back up and are we going to open schools or not and all of that stuff. I think the moment at which the market caught a bid and it put in sort of a bottom and it was still going to kind of have to bounce around a little bit and have some volatility because there's all the economic uncertainty. But the moment at which the really, really bad stuff was put in the rear

view mirror was the moment at which the market at least realized that there was a particular limit to the vulnerabilities, a particular focus of who was most vulnerable and who was most at risk, and that some of the systemic fears around COVID were not materializing. And that even as some politicians and even as some media and even as some citizenry still were wrestling with those facts and figures and realities and applications, the market said, okay, we at least know this stuff is off the table. And the market was right about that. What happened in March of 2020 had a lot of significance to COVID in that existence, that

global pandemic is what created the uncertainty that created the financial markets domino effect that led to that awful month that blew spreads out in corporate credit that totally broke down the securitized credit market, structured credit, which a good portion of which still is not fully recovered. And it generated, it exacerbated a lot of uncertainty and things like that in financial markets. But here's the thing that I mean is as old as the mere existence of a public equity market. There was mass selling around fundamental bad news, in this case the coronavirus, mass selling around fundamental bad news, in this case, the coronavirus leading to large portions of the economy being shut down for some unknowable period of time. And then out of the bad fundamental news became technical news that exacerbated it,

more forced selling, margin calls. In this day and age, a lot of the ETFs that were out there, you had technical factors that led to then more selling. Those technical factors created even worse fundamentals because now, all of a sudden, you have economic deterioration, you have a cascading wealth effect, you have effect, you have margin lines being shut down, you have bank lines being shut down, you have a sort of congestion in credit markets and just all kinds of defensive measures being taken in financials, which then the bad fundamentals that led to the bad technicals that led to more bad fundamentals then leads to more bad technicals. As you really call out of the shadows, the four sellers and particularly in March 2020, as was the case in September 2008, just unbelievable amount of shadow financial actors that operate off a significant amount of leverage. And in this case, it was high with risk parity hedge funds, quite levered and blown out of a lot of positions

that fell out of ratio to other asset classes. And so you just got this self-fulfilling prophecy. These are realities that existed before COVID, that manifested themselves during COVID, and that are going to exist forever. And that is in a leveraged financial system such as ours, one with fractional reserve banking, one with a lot of leverage, a lot of carry in our capital markets. The fact of the matter is that for selling exacerbates things to the downside. Now there was another lesson that was at play too. And that was the lesson of market timing. That even if one was going to try to time an exit and then time a re-entry, both of which I believe was almost inevitable. They were going to time wrong.

But that the snapback reality is when things get broken fundamentally and technically, and you get that sort of cascading effect, a negative feedback loop going on and pricing pressures to the downside, you're almost guaranteed of a very quick snapback that on a mathematical basis could represent 30, 40, 50% of the total recovery that come very quickly. You can have a nine-month recovery, but you can have 40% of it come in nine days or whatever the case may be. At the lower numbers, when you're moving higher, the percentages are higher because of math. The percentages are higher because of math. And we saw it in 2009 and we saw it in late 2002.

And all economic recoveries have gone this way in the market. So these things that we learned about market timing, about the danger of market timing, about the opportunity cost, about forced leverage, about it feeling like it was different, that it's not just a temporal moment, that this something felt like it was permanent, like it was broken. That is extremely common. They all feel that way. They all feel different. We only get to talk about it in the past tense. We only get to talk about markets recovering because markets have now recovered. It is in the past tense. We only get to talk about markets recovering because markets have now recovered. It is in the past tense. So you have a little hindsight bias because you're able to speak about it without a full appreciation for what it felt like at the time. But my point is this. I don't look back at the COVID moment and say, okay, I really learned my lesson. Now we

know there's forced selling that could take place. I already knew it. We've already allocated portfolios around that. We talked about it when it was happening. We've talked about it ever since. It's going to happen again. I don't talk about the specifics of COVID as something that all of a sudden changes the whole world. Like, okay, well, now we know that a virus can come and therefore we can't ever invest the same way because we just face a sort of risk of perpetual lockdowns,

perpetual sickness, perpetual vulnerability. Because I already knew that if, even apart from the risk of viral pandemics before, there's always been a risk of something, of war, of pestilence, of famine, of external circumstances that create great damage. And even apart from things I could list and identify, there's the risk of black swan events that are unforeseeable and unknowable. And those things are there right now as well. unforeseeable and unknowable. And those things are there right now as well. Now, what I am referring to as wanting attention is, first of all, about the things I've already talked about, having gone through it in March of 2020. Did anybody experience something that surprised them where they say, look, I thought I'd be comfortable with XYZ equity volatility.

I was not comfortable with it and I'm grateful things recovered, but now I just really need to revisit my overall asset allocation. Now some may have, but let me tell you what I'm not saying when I say that. What I'm not saying is I think the market is right now overpriced. It's going to go lower. I want to sell down a little. And then once it comes back higher, then we'll buy more. And then we'll... I'm not saying using that line of reasoning to form a tactical perspective or tactical idea on how you're going to time in and out and all this type of stuff.

I'm saying, did someone realize that structurally they have a lower tolerance, a lower risk appetite than they thought that they did? And frankly, I believe that that's common and totally understandable and there's nothing wrong with it, that it's one thing to talk to your advisor. It's one thing to look at a piece of paper, it's one thing to even talk to your own spouse and have a certain view or understanding of what you can live with,

but then to go through it, it can often be different. So it's worth kind of revisiting risk, it's worth revisiting expectations, but then as the point I've been making over and over, and now I'm finally ready to start the podcast, is that we have entered a zero interest rate world out of the COVID moment. And unlike the zero interest rate out of the financial crisis, where we still had a steep yield curve, that it was 0% of the short end, but it was 3% or higher at the 10 year and 4% or higher at the 30

year, that now we have it basically down between 0% and 1% all up and down the yield curve. The curve is flattened and not just flattened, but flattened at zero. And that reprices all risk assets in the economy and it reprices our expectations around the bond market specifically. And that we expect a different return, different carry, different yield, which by the way now means no return, no carry, no yield, out of boring bonds for quite some time. And we expect to have less of a risk mitigation in our portfolio. When equities get highly troubled, we would expect that the boring bonds are not going to help a lot. They shouldn't go down a ton, but they're not going to go up a ton to mitigate that risk.

So the sole function now becomes a parking lot protecting your capital in the form of capital preservation. What Operation Magnify is about is our ability to sit with a client and restructure the client portfolio around the major asset classes that are appropriately differentiated from one another. Core dividend growth is how we manage money at the Bonson Group. We believe in the risk premia that we can derive from companies that are growing profits and free cash flows and distributing a greater portion of those year by year by year with us. Dividend growth offers liquidity, it offers income, and it offers growth. And I eat, drink, sleep, breathe dividend growth equity. But then we use diversifiers in a client portfolio to supplement the realities of

dividend growth equity investing. And fixed income has played an important part of that for many, many years. I now am dividing fixed income into two totally distinct and separate asset classes from one another. Boring bonds, which are high quality corporates, high quality municipals, high quality Fannie Freddie mortgage agency bonds, high quality treasury bonds, things that don't have credit risk but instead have a very, very low interest rate environment but with a maturity date, with a very high degree, a very high assurance of capital repayment. And I'm separating that from credit, which are things that offer a higher coupon, a higher yield, but are juicier. And that means more volatility, but also more potential return. And there's where you look at high yield bonds, you look at floating rate bank loans, you look at emerging market debt,

and you look at structured credit, asset-backed securities. You can have some pretty juicy yield there, but you're going to have some up and down movements. So when you have a COVID-type moment, credit's going to operate more like your equities than it is your bonds. But in a more normal moment, you're going to have less volatility than equities, and you're not going to have the upside of equities, but you're going to have a really nice coupon, a lot of yield. So we have prepared a deck, we've prepared a thought process, we've prepared a reorientation and Operation Magnify to walk through with you. Do you need more income enhancement in your portfolio? What are some of the things we can do to enhance the level of yield across your diversified portfolio?

Do you need none of that at all? If you're not taking a high cash flow extraction, you don't need income generation at all. So there may be some clients that need to add more. There may be some clients that need to add some because they don't have any. There may be some clients that have this in their portfolio now and don't need it at all. that is suitable. And we want to offer growth enhancement where that's suitable, but we don't want to do it with the FANG names. We don't want to do it with the stuff everyone else is doing. We don't want to do it with stuff that we think has a disproportionate risk reward trade-off. We want to find tomorrow's great companies, have the risk, have the volatility, quantify it, understand it, know it, and look to your emerging markets, your small cap, your mid cap, other asset classes that are on the equity side of things but are outside of dividend growth that we can use to enhance growth and total return in a client portfolio. So we have a fair amount of that that we want to look at.

Some clients that maybe have 8% of that in their portfolio, but they want 20. Some that have 10 now and they don't want any. They just want to stay within the core dividend type approach. We have to have these questions and answer these things with core dividend, getting that weighting right, the boring bonds getting that weighted right, whether it's the current level or going down to 0% or somewhere in between. And out of that, then answering where does income enhancement fit in, where does growth enhancement fit in, where does credit fit in? And then, of course, where can we keep risk, therefore having the chance of return, and yet not have all that risk piled on in our equity beta?

And that's where alternatives come in. So we believe that this represents a very valid structure. It's going to be at the heart of our proposals we do. It's going to be the heart of how we're allocating, making allocation decisions. It's going to be what all of our portfolio reviews center around and the investment policy statements we create for clients. And we think it starts with a conversation for those of you already clients. Hey, let's revisit risk. Let's look at what we're doing. Maybe no changes are needed. Maybe some on the margin are needed. And maybe a total overhaul is needed. But we want to magnify the principles we believe in about dividend growth, about

alternatives, and magnify the thoughtfulness around the reality of investing in a zero-interest world and optimize client portfolios in the fourth quarter of this year. And we want to do all that, not because of new things we found out from COVID, but from things that already existed, but that COVID re-highlighted. And then the economic realities coming out of COVID of a disinflationary pressure and the idea of being at a zero interest rate environment for a very long time and what that needs to look like across your portfolio. That's what Dividend Cafe is about here this week. Lessons we already knew, but lessons now being magnified and applications being magnified in the portfolios of clients that we manage. We hope this makes sense.

Please reach out with any questions. We'd love to dialogue further with you about this. I do hope you enjoyed yesterday's inaugural edition of the dctoday.com, our first daily missive, and that will be coming back to you on Monday as well. In the meantime, for your podcast listeners, video watchers, and those reading dividendcafe.com, please have a wonderful weekend. We hope you got a lot out of this and sure look forward to talking to you again next week. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC.

Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. I'm Matt Levin. Thank you. Hightower shall not in any way be liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal advice. This material was not intended

or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions. Thank you.