The Dividend Cafe - Markets Settle and Rebound

Episode Date: February 16, 2018

This week, Chief Investment Officer David L. Bahnsen discusses: Topics discussed: The re-pricing of stocks in tug-a-war The tragedy of higher wages When things get this screwy, they also get this good? Links mentioned in this episode: www.DividendCafe.com

Welcome to the Dividend Cafe, financial food for thought. Hello, welcome to the Dividend Cafe podcast. This is David Bonson, Chief Investment Officer, Managing Partner at the Bonson Group. And we are into a very different week this week than we were last week. So we're titling this week Market Settle and Rebound. And I guess the settlement needed to happen before the rebound could. But I'm sure a lot of you are encouraged to see that things are not dropping a thousand points in two different days this week. The reality is, is that volatility last week came back so violently that it just kind of

disrupted the whole structure of the market. And we're going to talk a little bit this week about where we are kind of more fundamentally. And then as well, of course, just technically get into a little bit as to the aftermath of kind of last week's panic and so forth. a little bit as to the aftermath of kind of last week's panic and so forth. So let me do this. I do need to encourage everyone to go to DividendCafe.com. And a lot of times I want the podcast to be totally adequate. But this week, more than a lot of weeks, I mean, there's always charts. But this week, there's a few different, I think four different charts that I think are really useful to your processing of what we're trying to get into. So I encourage you to go there. But in terms of just

kind of debriefing, let's get into the lesson that is and the lesson that isn't. It's our firm conviction that most of the specific insanity of the panic attack correction of last week specific insanity of the panic attack correction of last week had deep structural and technical roots underneath it. Much coverage has been given to how the need to unload various inversed and leveraged and really rather silly products has exacerbated this market volatility and added to the pylon of market movements during the sell-off. We therefore have a duty to ignore false signals or noise that come out of transitory structural flaws in mechanical market functions. Now, that's not to say that there's not a greater narrative at play across capital markets, perhaps less relevant to the specific violence of down thousand point days,

but very relevant to how one wants to be positioned as an investor. If one believes, as we do, that the overall environment is in a subtle shift from deflationary pressures to inflationary ones or potentially inflationary ones, from tepid growth to greater growth, from monetary stimulus to fiscal stimulus, then the portfolio trends of the next five years would understandably look different than they have the last five years. For us, this means the opportunity of growing cash flows becomes more appreciated than the mere aspiration of a higher P-E ratio.

But it also means that global economic shifts create greater uncertainty and volatility as they play out. Survey says, If you accept that the major thing that will move markets for now is either the news about inflation or concerns about potential inflation, the Consumer Price Index figure for January was probably of great interest. The index rose 0.5% in January versus 0.3% expected. This amounted to a 2.1% increase versus a year ago in consumer prices. Energy prices were up 3% in the month of January, year over year.

Food prices only 0.3%, although that's actually a pretty significant move for food. Interestingly, hourly earnings were down, but core prices were on the rise. In our view, the 2018 will amount to a paradigm shift in conversation around inflation and inflation expectations as well in play. But let's be clear, we're nowhere near ready to say that this means inflation is back and staring us in the face. The numbers were not at all daunting year over year and markets were up 250 points the day of the CPI release, which was Wednesday. We know short-term conversation about inflation has created tremendous market sensitivity, but we're also cognizant of the fact that most central banks of the world, including our own,

have spent a decade trying to create inflation, unsuccessfully. The biggest issue we have to deal with is that conversation about inflation is not the same thing as inflation, and higher wages most certainly do not cause inflation. Flawed economic ideology is behind a lot of this confusion, but an all-weather portfolio approach has never looked so wise to us. History and volatility. I'm more sympathetic than you might think I am to the fact that what has happened frequently in the past doesn't have a lot of bearing on how we feel about the present. Nevertheless, my job is to present facts and data that have a bearing on you as an investor, even if they're insufficient in therapeutic value. The fact of the matter is that we have had unnaturally low volatility for a long, long time,

and in the last couple weeks have gone to a supernatural increase in volatility. long time and in the last couple weeks have gone to a supernatural increase in volatility. We were overdue for this and yet it quite quickly became overdone. Enough about markets. Let's talk economics. Q1 real GDP growth is projected to being up through, let's see here, being up over three percent and we do believe four percent for this quarter anyways is a distinct possibility retail sales are up nine percent annualized over the last six months the ism manufacturing print was the best in seven years in january the ism non-manufacturing read was the best in a stunning 14 years hourly earnings were up 2.9% versus a year ago. Earnings appear to be up 17% year over year this quarter. Global metrics are all at an upward trend

nearly across the board. Nearly. Productivity is likely bottomed and is geared for pickup. Durable goods orders were up 2.8% last month. Consumer sentiment at historically high levels. 200,000 jobs were added last month. So markets can go up or down in good or bad economies. But for those wanting to simply know the economy is doing, the data is rather clear. The repricing of stocks in tug-of-war.

is rather clear. The repricing of stocks in tug of war. There seems to be two conflicting forces that are and will call for a repricing of stocks in the months ahead. One is the higher bond yields we see taking hold in response to potentially higher inflation expectations and tighter monetary policy. A higher interest rate compresses equity premium for obvious reasons. The second is the higher volatility environment for stocks relative to the low volatility environment we've been in. Higher volatility enhances expected rates of return as the risk premium investors demand for higher volatility assets increases. A repricing of equities and a sort of clearing the deck of asset prices is a normal and healthy thing. In this case, there are a couple forces at play which will impact expected rates of return for the U.S. equity asset class. Interesting times. A pivotally important truth, even if it's not convenient. There's no

need to look for spin in this environment. The markets have done what they've done and the next phase will be what it will be. As long-term investors committed to client outcomes, we don't spin current events because frankly we don't need to. So take this as the objective fact that it is. Despite a brutal market correction in stocks, corporate bond spreads did not widen. This makes no sense at all if we were facing a fundamental revisit of systemic risk. Rather, it seems to us to indicate the market structure issues I spoke about earlier were behind the correction, much more than economic fundamentals. I will push back, by the way, as long as there is still a reporter uttering what virtually all economists know is false, and that is that higher wages cause inflation. The theory is that as employees

start getting paid more, they go out and spend more, which pushes up demand, and then that causes producers to raise prices. Then everyone else catches on, and voila, higher prices everywhere, inflation. But there are so many flaws in this thinking, it fails on its face. Inflation is an aggregate price level across society. Wages are one aspect of a complex economy and exist within the context of competition for labor, supply and demand, a whole host of factors. An increase in money supply above and beyond the increase in goods and services is inflation. Employers and employees cannot create inflation. They can only respond to it. The behavioral reminder, the $29 billion, B-I-L-L-I-O-N, B billion of net, net, net money that was sold from retail equity mutual funds last week has all the evidence of being classic weak hands money what i mean by that i mean people that were

convinced not to be in stocks the dow 18 000 or dow 20 000 or dow 25 000 then came back in at 26 500 upon the first bout of volatility jumped out. I've written about the second order, third order effects of market timing before. First, people are mad about their own exit timing. Then they're mad about their re-entry timing. And then they become incapable of reasoned decision making. It happens over and over and over again. What is the behavioral remedy? Avoid painful third, fourth, and fifth dominoes by never tipping over the first domino. Market timing is a fool's errand and makes for weak hands when finally invested in stocks. And no one with weak hands will ever survive invested in equities. And by the way, I asked for the theory that it was mutual funds last

week that had all the volatility and downside issues, which they certainly did. Note that in the ETF sector, passively, you had the biggest level of redemption in the history of the ETF space. 8% being withdrawn from the SPY, the spider for the S&P 500. Just crazy. from the SPY, the SPY for the S&P 500. Just crazy. I'm going to skip the section about backwardation in the VIX. It's a little complicated to get into.

A very funny tweet I quote this week, stock market rallies 300%, and then it drops 10%, and then a perma bear says, I was right. Happens all the time. Check out the chart of the week. One of the most important things you can see illustrated the intra-year volatility that exists time and time again in the stock market, including those 70 plus percent of years that the market is up. You still see significant movement in the middle of the year. It's not uncommon. What is uncommon is what we had last year i've repeated it but you see a chart there very important i'm going to leave it there for the dividend cafe podcast this week we'll see what next week holds

you have a monday holiday so a little bit shorter of a week and of course you never even know how this week will end up by the time you're hearing this but all systems are go right now with this little weekly rebound versus last week. And this is what we do at the Bonson Group. So you have any questions, you reach out to us anytime. We're here for you, working away, completely engaged, committed to being as intellectually prepared as we want you to be behaviorally prepared in dealing with the challenges of investing. Thank you for listening to Dividend Cafe. Thank you for listening to the Dividend Cafe.

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