The Dividend Cafe - Midterm Mayhem Inflating or Deflating Markets

Episode Date: August 10, 2018

CIO David Bahnsen discusses current markets from the basis for market optimism to the prospects for more capital expenditures, to the real debate behind inflation and deflation Topics discussed: Causes for Cautious Optimism Midterm Election and Markets Much more Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com Article on 20th Anniversary of Fracking @ MarketEpicurean.com

Welcome to the Dividend Cafe, financial food for thought. Hello, welcome to this week's Dividend Cafe podcast. This is David Bonson, the managing partner, chief investment officer, and lest I forget, was the founder of the Bonson Group, our beloved wealth management firm dedicated to bringing investment acumen and wealth management solutions to our clients each and every day. And as is always the case, we want to do this weekly podcast for you to just give you a fresh understanding of what's on our mind, what we're seeing in markets, and kind of mirror what we do in our weekly writing at DividendCafe.com. So markets are up this week. Again, earnings season

moves further towards completion, and it's obviously been a very positive earnings season. The continued statements around tariffs and retaliatory tariffs back and forth between the U.S. and China are being met with continued apathy at this point by the market. So we're going to dive in this week's podcast to the basis for market optimism, the prospects for more capital expenditures in corporate America and what we think that continues to mean, and the real debate behind inflation versus deflation. There's going to be a good coverage around politics and money, and particularly the role of the midterm elections in markets, and a few other goodies as well. So let's dive right in. As far as the basis for optimism, let me say something. Look, turning bearish on markets, becoming a broad-based pessimist on my outlook for the economy and risk assets is not something I'm afraid to do. the investing public loves listening to market bears. The mere novelty and the blowhard profundity of perma bears always finds an adoring audience. It's not in my DNA to alter my views on investment

allocation or market prognostication to quote unquote find an audience. There's evergreen principles I believe in that find a frequent voice in this weekly podcast. And there's the weekly perspective I offer, which is really just, you know, asking for me to be objective and calling balls and strikes as it pertains to our perspective on markets and so forth. The fact of the matter is I've actually been more modestly positioned as far as a defensive position or posture around equity allocation. Not extremely defensive, but modestly so for quite some time. Many would argue a little early. If I believe the catalyst was finally here for a substantive alteration or deterioration of equity market values, I would not hesitate to say so.

But that said, earnings per share growth remains phenomenal, up 23.5% year over year. And tax cuts cannot and do not explain all of that. Revenue growth, top line, remains quite strong, 9.2% year over year growth. The concern of rising bond yields has not proven to be a very legitimate concern as empirically equities have responded to the positive in seven out of the last seven periods of rising rates. Thus far, even the trade war issue, which I loathe and earnestly disagree with this administration on, but it still resulted in very low actual tariffs relative to past tariff flare-ups. I'm happy to advocate for caution in the high valuation growth sectors of

the market, but as for broad market health, especially in the more value-oriented arenas, and I'm going to talk a little bit more in a moment about that growth value distinction. My objective call is that earnings growth and economic expansion justify a cautiously optimistic market outlook. CapEx or bust. There is no more coherent argument for a continuation of the bull market than the argument that capital expenditures are on the rise, and in their continuation, a further run of productivity growth is coming that will be expansionary, healthy, and opportunistic. Of course, the thesis starts with the premise that

CapEx is indeed on the rise. Our thesis has been, and continues to be, that the corporate tax reform has created the economic backdrop for such. And then a follow through on this business investment will be the fodder for the next expansion. At DividendCafe.com this week, we have a chart of the 25% year over year change in CapEx. You can see quarter by quarter by quarter what capital expenditures were doing over the last four years and just a muted and in fact negative growth you were seeing in capex and now you can see the extraordinary expansion that has been taking place in the last quarter and forward deflation versus inflation well we put up another chart at different cafes.com that is basically just showing you how really for some period of

time going back to the turn of the century um obviously also a turn of the millennium that the uh the pce uh our favorite uh metric of measuring inflation happens to be the one the fed uses the most as well has really kind of just bounced around in a range pretty much below 2.5% per year. And even right now, we're only seeing that metric retrench towards the median level of the bandwidth it's been in for about 20 years. The sharp drop in price inflation from the classic deflationary conditions of the financial crisis has not even been recovered yet. The reality remains that a repricing of risk assets around the risk-free rate, meaning the Fed funds rate was at 0%, now is at 2%, and a 10-year is at

3% versus 2.5% where it was before. That's categorically different than adjusting for actual secular inflationary conditions. I'm working on an article, by the way, for marketepicarian.com that is going to be a bigger unpacking of the inflation deflation story. I mentioned growth and value a moment ago. I have the difficult balance to strike of not repeating myself ad nauseum on certain topics and also not assuming all readers have read or understand a given viewpoint. My discomfort with the distinction between growth and value is a

topic I've addressed many times, but I do not want to take for granted that everyone understands it. The nutshell is that I get what people mean when they use the terms growth and value, but I find them unhelpful in that a value company which has no growth prospects sounds like a bad investment to us, and a growth company where we have to overpay also sounds unattractive. By definition, no investment should or would ever be made if the buyer did not feel there was value and there would be no value without the belief of some renewed or accelerated or sustained growth. But with that said, the indexes of these respective styles

point to varying relative results. And we have, again, another chart at D at dividendcafe.com this week in which you will see exactly how growth has done divided by the S&P 500 and how relative how value has done relative to S&P 500 over the last oh I think we put the chart back 10 years and again growth relative to value has been the outperformer and there's been little zigs and zags along the way. Now, if you go back further, value had been a huge outperformer of growth in the decade prior. But my point is this. Growth relative to value, when you see the chart and understand the valuation, is historically and in any kind of empirical valuation sense expensive and value in the same valuation technique is is attractive and that's what we would say for those who want to try to

find a bias between the two quote-unquote styles by the way speaking of marketepicarian.com, this week I did post an article about the year our lives changed, the country changed, and the world changed. And I, of course, refer to that point 20 years ago in which the first real commercially successful use of horizontal drilling and hydraulic fracturing took place. And from there, the shale revolution began. Solving the trade deficit problem. Well, I'm hoping you caught the fact that me calling trade deficit a problem should, you know, perk your ears up because most of you know, if you listen to the podcast much, I don't actually believe that the trade deficit is a problem at all in and of itself. And that also means I don't

see a trade surplus as a necessarily good thing. Trade deficit can be a problem and a trade surplus can be a good thing, but it is not true in and of itself. And I think Venezuela would agree with me. But to the extent that one is looking to see a trade deficit shrink, and I think we can all agree that the president is looking for that, there is no lower hanging fruit for doing so than exporting energy, particularly to China. If China were to become a big net buyer of U.S. food and agriculture, it would give the president an incredible political victory of the declining trade deficit. It would give China the benefit of our energy and food, and it would really create a path towards being able to end a lot of the trade and tariff mess.

Now, there's still the intellectual property theft issue that has to get sorted, but my point is this not only represents a narrative that I can see becoming both a political and economic reality, but it is a highly investable thesis as well. Well, S&P 500 on the year now is getting very, very close back to the all-time high it reached in January. It's not quite there yet, but I put a chart up at DividendCafe.com where you can see the big move up that had happened in the S&P

through the end of 2017 and throughout January, then the big drop that happened in February. And then you see this little up and down, up and down, up and down that's been going on since late February all the way through June, where the market about three different times hit the same level of high and about three different times at the same level of low. But then now has begun that march out of that trading range and is getting very close to where the new highs were. Ultimately, those who in the midst of that volatility said, I want to go to the sidelines. I want to kind of be in cash, time my way out of this, and I'll come back in the market at a different time.

time my way out of this and I'll come back in the market at a different time. They now have the fun of re-entering the market five to 10% higher, or they can decide to continue the bet and try to catch another dip, so forth and so on. Market timing is a fool's errand. And that has to do with the next thing I kind of want to comment on, the whole idea of minimizing regrets. I've written in the past about the powerfully destructive force of regret in the life of an investor. It generally goes something like this. An investor gets spooked out of the market during a difficult time. The market recovers thereafter, the investor regrets his or her panic exit, but in the emotional throes of such a dilemma, the regret causes one to wait for a dip, often building up more and more regret for the exit, and now the waiting causing a crescendo

point where the investor jumps back in just in time for a correction, leading to more regret, just in time for a correction, leading to more regret, rinse and repeat. The regret dynamic in investing is unavoidable when one's ill-advised behavior puts them on the regret cycle. It is merely the human reality and manifestation of the great evil of market timing. And of course, we exist to end that regret. On the politics and money side, China's announced a new round of retaliatory tariffs, 25% on 16 billion worth of imports. That's in response to us having announced the same. Markets have not really moved, but you do have 250 items on our product list, including electronic circuits, motors, farm equipment, tractors, motorcycles. Same old, same old on the trade and tariff side.

The potential to adjust capital gain tax liability for inflation continues to have momentum within the president's economic team. The policy is sensible from my perspective, but one issue on impact lingers, and that is that if it is implemented, would the implementation be effective immediately, even in the face of inevitable litigation from those who would claim the Treasury Department lacks the legal authority to do it? In other words, I'm quite confident a lawsuit will come, and I'm also pretty confident the Treasury Department would prevail, although I certainly don't know that. But what's too early to say is whether or not it would begin implementation or they would have to wait through the headwinds of litigation. For now, we just continue to kind of be in a wait

and see around the whole thing. I do want to note, and I got to give a hat tip to my friends at Strategas Research because they sort of caused me to think about it, but individual states with high tax rates would be really big beneficiaries of this policy. Ironically, they're almost all blue states. The inflation adjustment at the federal level wouldn't matter to states. And yet, presumably, a significant amount of capital gain realization would take place as a result of this federal policy change. So states would receive tax revenue they wouldn't otherwise have received. And that would really kind of indicate to me that you would have an indirect benefit to municipal bond investors

in some of those states. Something worth watching. By the way, are markets likely to be impacted by the results of the midterm elections? I don't think so. Is the House likely to swing to Democrat control? At this point, I'd certainly say yes. Is the House likely to swing to Democrat control? At this point, I'd certainly say yes. Is the Senate likely to stay under Republican control? Very likely, yes. In fact, probably a couple seats would be added to the Republican column. Are these outcomes essentially what are expected of markets now? Most certainly. But beyond any of the political projections, the fact of matter is that there's very little of market implication expected under any result of this midterm cycle. Okay, I've talked about four different charts already this week that you podcast listeners

don't get to see, and now I'm going to cap it all off with another one, the chart of the week at DividendCafe.com showing.com showing us households leverage the debt divided by assets. And you can see how even as debt has very, very, very modestly climbed in the last period of time, the leverage has just utterly collapsed as our percentage on a household level of debt divided by assets has dropped to a level we haven't seen in many, many, many years, about 40 years. It is government debt and leverage that is out of control on an individual basis. You actually see a far improved environment since the financial crisis. So I'm going to leave it there.

Thank you for listening to the Dividend Cafe podcast this week. Please check out our Advice and Insights podcast for a special edition this week on stock buybacks and all the new controversy existing there. And as always, reach out with any questions you may have. We look forward to answering them, and we look forward to coming back to you next week with the Dividend Cafe. Thank you for listening to the Dividend Cafe, financial food for thought. The Bonson Group is registered with Hightower Securities LLC, member FINRA and SIPC, Financial food for thought. Thank you. Hightower should not be in any way 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 reference 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

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