The Dividend Cafe - Market Outlook w/ David L. Bahnsen - Conference Call Replay - September 20, 2021

Episode Date: September 20, 2021

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. Scott, I'm going to turn it right over to you. I assume those who are on the call right now, as guests and as clients are aware, this is actually the second time in the last few months that we've had kind of a big down day while we're doing one of the calls. But that is not anything that should be a big concern to us since, of course, the entire genesis of this call was the severity of market drama at the point of the March COVID moment. That's when we began doing these calls together, Scott. And so, yeah, if I remember correctly, we had like a down 900 point day a couple of months ago. And now here we are today as I'm sitting here talking,

the Dow is down 760 points. I believe it has been down as much as 850. And so I just sort of want you to ask me the question, Scott. I'm going to be here to answer, but we are in the thick of it and ready to dig in. And I'll reiterate Brian's point, real time, send your questions to questions at themonsongroup.com. We have people that are going to receive those emails and send them on to Scott in the middle of the call so we can hopefully address as much as what's on your mind here real time. I am sitting here in the Newport Beach office. I just flew back from New York City yesterday. And this is what we're doing here today. Scott, off to you. Well, David, thank you. Great to be with you as always. And we actually got a question that came in ahead of this call over the weekend prior to, of course, today's market declines. And we'll get to that question in a moment. But first, David, let's start with what we're seeing market-wise today. First significant market pullback, at least intraday, say perhaps since mid-July. I think July 19th was the last plus 2% decline in the broader index.

So what's your reaction in terms of what's causing today's declines and kind of how you're thinking about it? Well, one of the challenges when a market's trading at 25 times earnings, when it has had no drawdown anywhere close to even 5%, let alone 10% for almost a year. When you have had such an extraordinary period of market returns, of market valuation expansion, multiple expansion, such earnings growth, earnings recovery, earnings multiple movement, all of these things combining at once for such a long period of time is that there is no need for an excuse, no need for a reason whatsoever. And yet when it happens, it is incredibly natural to look to the first headline and

extract a cause and effect out of that. The answer is often that there is no cause whatsoever. Markets do not need a cause to have a 1%, 2%, 3% drop. Sustained multi-day 1%, 2%, 3% drops that equal 10%, 15%, 20%, those don't happen very often. But when they do, there is obviously a catalyst to it, whether it be a bubble bursting, whether it be a global pandemic breaking out, whether it be a crisis, a geopolitical moment. But when you're talking about something like this, there is no need for there to be a specific reason.

And yet, it often would be that if the reason is not that there's no reason, it's usually a combination of things that kind of came together and built up a bit of selling pressure. I think that the issue of this insanely over-levered real estate development company in China provides the media what it needs, which is the ability to put some hyperbolic headlines up on the screen and say some of the dumbest things that you're going to get to hear in a year. And that's always kind of good for me because it brings some levity to my profession. But no, the simplistic answer, the dramatic answer is probably not Occam's razor. Occam's razor is that we have a market that's very overvalued and you have a lot of people

that are able to give in to the anxiety of hitting the sell button when there does begin a bit of selling pressure. of hitting the sell button when there does begin a bit of selling pressure. And so when you combine the various uncertainties that exist, what will the contagion effect be of a Chinese real estate company, which is entirely financed by corporate debt and bank lending, most of which is state owned in China. What is the contagion effect there? Then you have the question about the $3.5 trillion spending package. And people can throw in COVID, they can throw in all different things. Usually people pick the thing that is kind of most convenient to a narrative that they hold. But the reality is it may be a small piece of all these things.

But at the end of the day, none of those things on their own are new enough of news to have done it for month after month after month. And most of it has been there. And so the combined effect of these things put together can give way a bit. And frankly, when you're talking about the levels at which you're selling from, the question is never, why is it happening? It's why now? Why not last week? Why not next week? And that's where I think we are. For this to actually become a moment of relief where you say, this correction is really out of the way. I think some people want that. I know I do.

really out of the way. I think some people want that. I know I do as a long-term buyer of equities. I had no plans to be selling the stocks in my portfolio this week. And so therefore, I'm very logically challenged just why I ought to be disappointed by days like today. Yet to really feel like, okay, I've been given a pretty good entry point here for a more significant re-risking of client portfolios. We're a ways from that. I really think you're going to want to see markets come down 10% from their peaks before you start saying these valuations look really attractively viable. Even at 10%, I'm not sure they're attractively viable, but they're more viable. So for now, we wait and see and let these things unfold. And I'm sorry for my very long answer. But last time this happened, I think you said it was mid-July.

If I remember correctly, we were down 900 during the call. We closed down 700. And then we went up 550 on Tuesday and then went up 200 three days in a row. And we closed that week up a couple hundred. And people could check my exact numbers, but I don't encourage people to challenge my memory very often. That week in the market, it closed up. And so I have no idea what the market does tomorrow. I just know that at some point, we have to get a real correction and we're not there yet.

Yeah. And I think prior to today, the broader indices were only down about 2% from their all-time highs in earlier September. So you add on today's declines. And to your point, we're still only about halfway there for a traditional 10% correction. Yeah, I'm not sure we're even halfway there. I think you're right. It's somewhere in the fours, probably, peak to trough.

Yeah. So you've been writing, though, a lot about China over the past couple months in Dividend Cafe. Any reaction to some of the headlines there today that seem to be at least contributing to some of the concerns investors have today? Well, the, the speculation and, and excessive leverage built up in some of the corporate sector is a big part of, of our, um, fact, uh, pattern that goes into some of the theses we're forming. We obviously have grave concerns about the reliability of the CCP and helping us to measure risk and reward the way we would want to. And so I am not particularly attracted to the various interventions that have taken place and the impact they've had in the Chinese Internet sector,

let alone the education sector and some of the other things, their hospitality, tourism. The heavy hand of the CCP on the equity side, as I've really gone to great lengths to try to lay out my recent podcast with Louis Gov of GovCal Research, three different dividend cafes dedicated to the subject, very consistent with our thesis about what is the actual strategic objectives of the CCP at this time. What we're describing here today is an entirely different story, but it very much plays into the reality of their state-owned enterprises. We only, thank God, in our country, basically had a couple of what we would call – we didn't even have the political ability to call them state-owned enterprises. So we made up this term called government-sponsored enterprises, whatever the hell that was ever supposed to mean. And so Fannie and Freddie were fully private companies that had what we called this implicit guarantee. And all that meant was that we could wink and nod and tell people buying the debt that if anything ever happened, the government would back it up. And then something happened and the government backed it up. And the bondholders got a hundred cents in the dollar and the equity holders got beat up a bit. And then they've

kept the company in conservatorship of the United States treasury department, which for those who remember high school civics is owned by us. It is a government by the people for the people. So we, the people, own Fannie and Freddie via government ownership. But we really don't do that in our country very much. There have been government interventions into distress moments and bankruptcies. We remember the TARP effect, which was primarily a backstop of lending. They ended up injecting some preferred equity, and that got kind of messy. They have obviously, over the years, had various what we call bailout situations with the ended up injecting some preferred equity, and that got kind of messy. They have obviously, over the years, had various what we call bailout situations with the automotive industry and other things.

But those things are always the exception, not the rule. And then there's a lot of controversy around even those moments that happen as exceptional as they may be. China is the norm. It's the rule. You have a significant amount of corporate debt that is backed by government or is bank debt to companies. This gets more complicated. Bank debt to a company, but then the bank itself has CCP ownership or connectivity. So effectively, the counterparty still has risk of loss. It has P&L risk to the government. So I am not going to sit here and tell people that by Thursday of this week,

China is going to bail out this company because I don't have any idea what they're going to do or how they're going to do it or when they're going to do it. But I do most certainly know that they're going to do what they deem to be in the best interest of CCP. And a $300 billion hole in that balance sheet is not going to be in their best interest. So they're probably up to some kind of back channel shenanigans, and that'll play itself out. But these are not US bank lenders. The counterparties are not US bank lenders. And the bonds have been dropping around this real estate company all year, severely so. So when an American bond drops from 100 to 95, that could be interest rates. When it drops from 95 to 90, it could be concern about its stability. When bonds are trading at $0.50, it's someone saying there's

going to be a default, there's a distress event. When bonds are trading at $0.20, it's someone saying this company is being left for dead. The bond market is pricing in these realities. And other than unexpected governmental interventions, like when the Bear Stearns deal was orchestrated by the Fed, backstopping the first $40 billion of losses, which enabled their buyer, JP Morgan, to come in. And all of a sudden, that effectively meant those bonds were money good. And the bonds traded from $0.67 of the dollar back to par value, even as the equity got wiped out. Other than moments like that, when you have bonds trading at basement levels,

it's because they know that the company is insolvent or has significantly more liabilities than its equity can withstand. And the bond market has been saying this for a long time about this company. So the question is just what CCP is going to do. I would not try to make any money guessing, but I don't believe that it's going to have a tremendous impact to the American companies that sell diapers and laundry detergent. David, I also want to go back to valuations, which we talked about earlier, but we just got a question from somebody on that. They want to know your thoughts on the variety of companies out there with astronomically high valuations.

And this person brings up a few companies in particular, which I'll just paraphrase. They mentioned a very well-known electric vehicle maker. They mentioned a very well-known movie theater chain. That company has gotten a lot of attention so far this year. Any reaction to that category of stocks? They're not investable for us. We tend to believe as a permanent and evergreen thesis of our investment management that we would like things to be able to be rationalized on a pro forma basis. It's very difficult to use discounted cash flows to value a lot of these types of companies. In the case of some of these so-called meme stocks, I can say that word, but I won't go into the specific names, but ones that were originally

orchestrated around trying to create a massive short squeeze. It was very successful in doing that. And then now on a go forward, what is the destiny for some of these companies? They're completely uninvestable for us. Anyone who invests and makes money, I'll be happy for those people, but they're most certainly doing it out of speculation with a high potential reward and a high degree of risk. And no one has ever been able to prove to me the measurement of that risk and reward calculus that the odds are any better than being in Las Vegas, where they provide free beverages to people. Okay. So I don't do it. The bonds group doesn't do it. That's different than electric

car vehicles and some of the technology companies and innovation that is wildly valued, but it's being valued because there is a sort of uncertainty into terminal value. You don't have the ability to put a price on the unknown platform of a fully scaled battery, electric vehicle scenario, certain biotech things that at an infant stage, you can't know how broad the utility may be. So there are things out there in the technology space and in a much lesser degree, I use biotech as an example, because I don't want to always be picking on the tech sector. My point is that in that case, I think that people have to just understand that investment in innovation at these levels, you have a lesser expected rate of return, and a higher risk-reward calculus to overcome. In other words, the risk-reward burden is less favorable than it used to be. And yet, the fact of the matter is there's a few companies a decade that tend to end up rationalizing what was at one point

extreme valuation and then at some point come to more normalcy. So I won't tether an opinion here on this interview and this discussion about any particular company. But my view is that extreme valuations, when I can trace them to euphoria in the investing public, are almost always going to end very badly. When it is prior to euphoria in the investing public, and yet it still seems nonsensible to me, there is always those Darwinian stories of just incredible survival and incredible thriving that lead to a sort of monopolistic position in the marketplace led by groundbreaking innovation and whatnot. But right now, it's very hard for someone to look at some of those companies that have already had the moves they've had in the last, let's say, 18 months and be able to argue that a lot of that post-positioning is not already priced in. So it comes down to the investment

objective. It comes down to the risk profile. It comes down to financial personality, to liquidity need, the cash flow needs, all of those types of things. But there is absolutely nothing in that tech-oriented space of the market, micro-cap or mega-cap or in between, so-called work-from-home type names that got real big during COVID, recent unicorns and IPOs that are, in a lot of cases, more highly known brand names now. None of them look to me to be affordable. And yet some will end up having stock prices go higher, no doubt. So we have an investment philosophy that enables us to be removed from the process of guesswork. And it is a passion of mine and all my colleagues and

partners that we wish more people would remove their investment policy from rank speculation. Usually, it's not very hard for people to say, you're right, I don't want my financial goals to be tied to rank speculation. It's just harder sometimes to demonstrate when that is what's happening. David, just to go back to our topic on China from earlier in the conversation, we're getting another question about that, which you addressed in many ways already, but I'll just repeat it again, just in case this person is just joining us. They want to know what a slowdown of the Chinese economy means for the US stock market. And we perhaps saw a glimpse of that kind of dynamic today, but are there any broader themes that you'd want to add to that?

Yeah, I think that a slowdown of the Chinese economy, meaning total global trade, that if there is less exports going on and therefore less imports going on on our end or on the European end, that there is absolutely a contagion effect around macro appetite and macro supply-demand dynamics. So you can word this the other way, too. The most likely scenario that hurts China's economy as an export dependent one is if there is less demand for their products from their customers on the American side or the European side. And that's where I believe that kind of cliche about if China catches a cold, the rest of the world gets sick. And I think it's worded differently.

I could China sneezes, the world gets sick. But, you know, that started off as an American cliche. And that is still even more true. The question now, when you look at excesses in the Chinese financial system, is will that result in less exports? I'm not at all convinced that it would. But it doesn't mean it won't. But you have to separate the category of economic challenge in China. The excessive and speculative leverage from their non-bank lending space has been there all the way since the financial crisis. And yet they've had unbelievable growth economically through that whole period. So I think that you can have any number of things that impact China and their size in the global economy and their role as the leading exporter of goods to particularly Western economies, but

also other Asian economies. There's just no question that that would have an impact to global GDP growth. But the question was, how would that affect the US stock market? I think it would affect it very differently in different sectors. There's a lot of our technology supply chain heavily reliant upon China. That got shut down. That would impact the ability to generate top-line revenue for a lot of those tech-oriented companies or manufacturing companies that have a high degree of supply chain dependency in China. It would have much less of an impact in, let's say, utilities, consumer staples, and healthcare. I haven't looked at my screen in the last 20 minutes, but the few things that were

up this morning were American pharmaceutical companies, American telecom companies that are considered more defensive sectors. Well, what are these things all have in common, Scott? They're the sectors that have been lagging most all year. And they're called defensive for a reason. They have less cyclicality. They have less volatility. But it also just so happens that, to your question, they have less relationship to China as well. So I would expect, if you were to actually have global GDP challenges that originated

in China, that the impact to US would be none in certain sectors, minimal or little in others and severe in others still. David, let's also talk about taxes as maybe kind of the last topic of our discussion today. Obviously, lots of headlines over the past week about potential tax increases tied to the budget bill. Your broader view on that? I know it's a pretty broad topic and there's a lot of uncertainty there, but what do you think people should know right now? Yeah, I think that people really should read the dctoday.com today because I was able to put quite a bit of unpacking on the tax expectation and the spending bill expectation into today's commentary. And so usually you'll ask me what lies ahead for DC today. And today has got a lot of stuff on today's market action. There'll be more to come that I surely will write this afternoon and a lot on the public policy front. And I remain really very unsure as to how

this fundamental tension point gets resolved for the White House, which is that there seems to be a lot of resolve that apart from the infrastructure bill passing first, that they won't go forward to the reconciliation bill from a couple moderates in the Senate and more than a couple moderates in the House. moderates in the Senate and more than a couple moderates in the House. And there appears to be a real digging in the heels of the exact opposite view that there will not be a vote on infrastructure unless it is directly correlated to a simultaneous affirmative vote on the reconciliation package from some of the progressives, both in the Senate and in the House. And so this, that chicken or egg thing can't get resolved unless one side capitulates.

Or on the infrastructure side, what if you have a scenario where the progressives follow through and say, we're going to vote no on the infrastructure bill, yet there's enough Republicans in the House that vote for it, enough Republicans in the Senate house that vote for it enough republicans in the senate have already voted for it that they don't need the progressive votes that they lose so the infrastructure bill still ends up passing and then there's like no leverage with the progressives on the on the uh on the reconciliation bill so i don't, I would not put that as a 50% or higher chance of happening, but it's on the radar right now. Of course, there's also the possibility of both

bills blow up entirely. And then there's also the possibility that they keep fighting and yelling and threatening, and then they end up kind of doing something in the end. But when you ask about the tax side, the initial first shot across the bow was for a capital gain tax of 39.6% at the high income level that then also had a 3.8% Obamacare surtax. So you're talking about a 43.4% capital gain tax at a federal level. And remember, the capital gain in the states is the state's ordinary income level. So for states like New York, California, you'd basically be getting to about a 57% capital gain. Well, now the actual House Waste and Means Committee, the Democrats, have come back with

a 26% proposal on cap gain. So that takes the delta from the 20 it is now to the 39.6 they wanted, and it puts it at less than half of the way towards that. Now, I don't know that they're going to be able to get that done either, but I just want to make sure that the conversations people are having are around the realities of what are still on the table. The corporate tax at 28, they've already moved that back to 26.5. And you have several senators that said they won't go any higher in 25. So those are the two big ones that I've been pretty on the record all along saying, I think that if they're going to get anything done, which is a TBD, they're going to get 25 on

corporate and they're going to get 28 on cap gains. Far, far, far lower than what had been proposed. Then there's some of the other stuff that gets really, frankly, quite insane. Taxing unrealized capital gains at death. That's pretty much already shot up. There's more than enough people on both sides of the aisle that have said no to that. I don't think that advances past committee. And a lot of that was even killed in the House Ways and Means. There are other things that we don't know about still. So there's a lot in motion. What you do know is that apart from budget reconciliation, apart from a bill that 50

Democrat senators vote for, none of it happens. None of these taxes are about to sunset away, which was the case back in 2012 going into what they called fiscal cliff of 13. back in 2012 going into what they called fiscal cliff of 13. So the status quo is what you default to unless they pass a bill using budget reconciliation because obviously they're not going to be able to get filibuster proof any of it. So then the question is, what is the bill that can get passed that would pacify Senator Sinema and Manchin or the two most public on the Democrat side? And then, of course, there's a whole lot of competing interests within the House Democrat side,

the moderates in the House. And those are different things in some cases. There's people demanding certain drug pricing initiatives and people pushing back at that. There's some House Democrats that have said that it's a non-starter if they don't get the SALT deduction back, which was the state and local tax deduction. They did caps at $10,000. They want an increase there. There's other sides that say they won't even touch it. So there's a lot out there, and I just don't know yet where they're going to reconcile those differences. What about, I guess, some of the proposals for small business owners, I guess, taxing not necessarily the super, super wealthy, but those who are doing well, so to speak, maybe they have their own business. Any take on the likelihood of that coming to fruition? I think it's incredibly unlikely. I do say that as a good thing, of course, but it was in the Biden proposal to both take away the deduction that was part of the 2017 tax bill for pass-through entities, for certain, or law firms. But for a lot of S-corps and subchapter S-corporations and LLCs, there was a deduction provided off that net income. And the proposal was to take that away

and then to provide a surtax. And I want to say it was 3.8% of any income over a certain level, $250,000, $400,000, above and beyond. So it'd be two tax whammies. That was in the Biden proposal. And I was really on record earlier in the year saying that actually, I think, was more detrimental to the broad economy with over a million such entities in the country than even the corporate and capital gain investment income taxation changes that were being proposed. But two things have happened since that make me think it's pretty much dead in the water. And that is the amendments that were passed the night of the

budget reconciliation that insisted on defining a small business of reaffirming that there would A, be no income tax increase in small businesses and B, reaffirming a small business is one of 500 employees or less. So by implication, it was essentially saying most of these LLCs and S-Corps were going to be off limits from anything that would increase their net taxation burden. And then the house ways and means didn't go after it that way either. So I think you have a couple of things that have indicated they don't have the political capital to do something like that. But again, until we get final bills, final committees, and then ultimately conference, all of this is still a TBD. And I mean, do you think the markets are sort of reacting to that uncertainty or do you think markets are kind of looking past some of the tax discussions? it'll be at me for saying this, but to say that the market is today deciding to rebel against the proposed Biden tax stuff is a little self-serving and kind of silly. Because first of all, the

Biden tax stuff is probably right now as vulnerable as it's ever been. It has a weaker hand right now than it had a month ago, three months ago, six months ago, both from a political capital and approval rating standpoint to just the very explicit words that have come out of some of the moderates whose votes are needed to pass it. So I don't believe that. I don't believe that. And then not to mention the fact that through all of the proposals of the legislation, the markets have never believed that it was going to happen. And so I don't see any reason at all to all of a sudden say today was the day the market decided to respond to that. And David, final question here, moving away from the news of the day and the markets. Somebody is writing in wanting to know about your thoughts on alternatives, such as private credit and private equity.

Is that investment getting too crowded in your view? Yes. I saw that question over the weekend. I appreciated it because I talked a lot about the private investment space in last week's Dividend Cafe, dividendcafe.com for those who are interested. And it was a huge focus at the SALT Conference last week, which is the premier alternative investment event. And I think private investments right now

have one of the premiums investors are after still available, that illiquidity premium that certainly in other aspects of the alternative space, you've seen various premiums maybe get arbitraged away or priced away. And so we remain really a big fan of a lot of the private investment world, both debt and equity, all contingent upon other conditions being there, underwriting quality, management team, thematic approach. There's a lot that we care about and how we would affect our investment placement into private credit and private equity. But as far as the idea of the

space getting too crowded, I don't agree. But I do agree that the burden is bigger. The dispersion of results is so large that the burden is bigger for selection, for diligence, for talent. And so it's not about the space being crowded. The space being crowded is a reference to what we would call beta. Like there's just this limited opportunity set. And now you're either all betas overpriced, meaning the broad space or not. And it isn't like there's an index of lemonade stands out there, the proverbial small business opportunity. When you get up into mega cap leveraged buyouts, there's no question that they're paying higher multiples now on the

acquisition front, but their cost of debt servicing is way lower. So a lot of these mega LBOs pro forma better at a higher multiple now than they used to at a lower multiple five years ago because the cost of capital is so cheap. Now that can become distortive through time, cheat. Now, that can become distortive through time, but it isn't technically infinite, but it's for our purposes infinite of opportunity and private debt and credit. There is a gazillion things out there. What is highly scarce is the talent to apply themes or a strategic priority to the personnel, to the execution, to deliver attractive investment results. So I don't think there's a scarcity of business opportunities, but I do think there's a scarcity of talent to find them, and that's our job. So the answer is sort of mixed for the person who asked the question.

I think that there is an asset class abundance, but a scarcity of talent. All right. Well, David, I think that's a good place to leave our conversation for today. Stock's still at session lows, NASDAQ down over 3% right now. And I'll toss it back to you. Great discussion, great insights as always, David. Thank you. Well, Scott, thank you for leading this discussion. As we look, you're right, we're at new lows here and we have an hour and a half or so, a little less than an hour and a half to go in trading today. So we'll see what happens today, tomorrow, what have you. For the vast majority of you that don't care whatsoever what the market does today, tomorrow, and the next day, congratulations, because that is the right view. For those of you that these things can be

unnerving, it isn't that you're doing anything wrong, because there's nothing wrong with feeling a certain way. What is wrong is acting on it. No panic selling, no panic buying. It is possible that some cash we're waiting to deploy, we may end up deploying here in the final hour. But I actually suspect we might even wait until tomorrow here. Because again, I just want to reiterate, 2% and another 2% down is a big number when you say down 900, but it's down 900 from these 34, 35, 30,000 levels. And as a percentage, it isn't what it used to be. It sounds different than it is mathematically. I believe that we could end up getting to a point this fall that for the first time, you actually feel like, wow, you're kind of buying at a better place in terms of the longer term expected rate of return. You get a diminished expected rate of return, the more expensive you're buying.

So I can't tell you right now here what we'll end up doing in the final hour at TBG. But I do know that I have long expected and long awaited and long even hoped for some degree of a setback. I just don't know yet if this will be it. But the S&P has dropped below its 50-day moving average. And it had tried to do that, I think, eight or nine times and not done it. It has done that. And so we kind of follow through with as it goes. But if it can get much lower, then we may be able to risk up a little bit. But for now, we're not panic buying any more than we would ever, ever, ever, ever panic sell. That's our story, and we're sticking to it.

Because Erica's not here, I'm not going to send you back anywhere else. I will just dismiss the call and thank everyone for participating. The replay will be up either later today or early tomorrow. Check out the dctoday.com for our end of day market action. Reach out to your advisor if you're a client of the Bonson Group, have any questions at all. Thank you, Scott Gamm, and thank you for being a part of today's call. 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

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