The Dividend Cafe - One Decade Is Not Like The Rest

Episode Date: September 14, 2018

This week, David breaks down the week and remembers the events of a decade ago Topics discussed: The Great Recession Trade War Leverage Tax Reform Isn't the Only Reason for the Economic Bump Links mentioned in this episode: TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson. I'm the Chief Investment Officer and the Managing Partner of the Bonson Group. And we are bringing you our weekly market commentary. And what a week it's been. Not actually all that particularly eventful in the markets this week, although as I'm recording here Thursday, markets are up a

couple hundred points and there's, you know, been a little bit of movement here and there. Nothing too dramatic. Talk about potential, you know, back to the table type stuff with China. potential, you know, back-to-the-table type stuff with China. But when I say what a week, I mean the fact that this is the solemn memorial week of the 17-year date of which the 9-11 terrorist attack took place. And I'm here recording today in New York City, the spot of this ghastly event. And then we happen to be this week now at the 10-year anniversary of the financial crisis. And by the time you're listening to this, we should be at the actual 10-year anniversary of the date Lehman Brothers declared bankruptcy. And then the Merrill Lynch, you know, movement into Bank of America, followed by the AIG bailout, followed by the big changes at Morgan Stanley, Goldman Sachs,

and what ended up happening there to keep Wall Street from totally imploding. And then later into the month, Wachovia and Washington Mutual. And so there's this chain of events that all started 10 years ago this week. So if you listen to our Advice and Insights podcast, I have a little bit elaboration on some of that and just kind of a little commentary on what exactly did take place 10 years ago. Advice and Insights podcast, separate from this, check that out. And I've been writing a little article day by day at marketepicarian.com. And trying to keep these articles short, but just a little series kind of reminiscing a bit as to what was taking place right on that given day 10 years ago.

And so throughout the days ahead, and there's quite a few markers still to come, I'm going to be talking about what was going on in that day 10 years ago. And then at the end, I'm going to wrap it all up and talk about what it means for investors, what the lessons are and were and will be, and try to make something actionable and practical out of the whole thing. There's no shortage of opportunity for application when you're talking about what was a world-changing event. And so that's what I mean by big week. Just a lot of heavy stuff. I'm here in New York City where these things took place, both the 9-11 attack and the financial crisis. And it has a, you can feel it in the air, there's a certain

heaviness to it, and I think that it's important we cover these things, discuss them, give you some insight. Let's talk, though, real quick. One of the things we did at DividendCafe.com this week that I really find very interesting is look at the CPI, Consumer Price Index, so that what some would consider to be a measure of inflation, the operating earnings of the S&P 500 and that PE ratio, the multiple valuation put on the stock market, the 10-year Treasury yield, the bond yield in the 10-year, the tax rate on dividends, the tax rate on capital gains, and the nominal GDP, the pre-inflation economic growth, average each decade going back to the 1950s. So you get a chance to look at the 50s, 60s, 70s, 80s, 90s, 2000s, 2010s, and then all those different metrics that go into that, and then where we are

now. And what you end up seeing is that we have an average inflation rate that is much higher than what we have right now. You have a market multiple that is mostly in line, and yet a bond yield that is significantly lower than the historical average and a dividend tax rate that is half of its historical average, capital gains tax rate that is below its historical average, and nominal GDP growth that is above its historical average. All the data put together and being able to view it and look at it and interpret it in the context of other decades doesn't lead to a clear, indisputable, bullish conclusion. But it goes a long way to dispute the idea that this is a black and white, obvious, evidenced, overvalued market.

What it is is a very, very, very divergent market. What it is is a very, very, very divergent market. Issues, securities, sectors within the market diverging from one another. Some things being overvalued, some things being undervalued. You have a growing economy at this time. You have a low cost of capital in the market. You have a very competitive tax on that growth and investment success via dividend and capital gain. And you have an inflation rate that is not eating away at these various things, which has happened in past decades, like the 70s in particular and the early part of the 80s as well. What's the Fed doing? Well, they continue to raise rates. They're going to raise it another quarter point next week. And they're very likely now the futures market's pricing in an 82% chance

of another rate hike in December. That was 62% chance a week ago. So the strong wage data and jobs report that came out last Friday kind of told the market, look, this is going to happen. The Fed really is trying to get to that normalization equilibrium. Let's talk about the yield curve issue. This is a little more granular, but I don't always want dividend cafe to be perfectly easy to understand and totally popular and applicable and easy. Sometimes you want a little meat on the bone. you know, popular and applicable and easy. Sometimes you want a little meat on the bone. This isn't actually that complicated, but if it turns you off, forgive me. Does a yield curve inverting point to a future recession because of something graphic on the chart? Or is the graphic on the chart, the visual illustration, simply telling the fundamental story, which is what

actually speaks to the reality of recessions? Well, obviously, it's the latter. And with all of the talk that we hear about concerns over a flat yield curve, it really concerns me that no one is actually speaking with the foggiest idea of why that exists. They're right about the correlation over the years between an inverted yield curve and the eventual onset of recession. But is the yield curve pointing to something or is it the cause of it? Well, it's pointing to it. And what it's pointing to is very simple, that interest rates being higher than the economy-wide return on invested capital is the cause of recessions. You have inverted economics that becomes recessionary. That inversion where interest rates, the cost of capital is higher than the return on invested capital is not organic, it's not normal, it's not natural, and it's obviously not sustainable. So

something is impure when that happens. It has to be purged, and a recession is the vehicle that purges it. The marginal rate of return on capital must be higher than the cost of capital. And a return on invested capital that increases can allow the cost of capital to increase, but it's the relationship between the two that tells us the most important thing we need to know about economic health. So that is the reason why a flat-ish yield curve can actually persist for many years, and the economy and investment assets can even do very well, is that the cost of capital doesn't end up exceeding the return on invested capital, even when those two metrics become tight. Now, we don't have a lot of periods where that's happened, but the periods we do, like the 90s and there's others that are shorter lived, have been very opportunistic for investors.

So I don't know that we're going to stay flat. I think it's very possible we do invert, but that would be a policy error, an avoidable policy error if it were to happen. And if that were to happen, I would think it would be almost for sure that at some point thereafter, we would end up in a maybe mild, but some form of recession. Okay, I'm going to kind of move through a few other things real quick. The whole idea about tax reform and what it's meant for profits growth. You know, we've only had profits growth because of tax reform. I don't really know why an investor is supposed to find that catalyst to be illegitimate or unsustainable, but it is inaccurate. If you strip out tax reform, I don't know why you would. Again,

it's a legitimate aspect of what the investor is tangibly receiving in the form of better after-tax earnings. But if you strip out the effective tax reform and after-tax earnings, you still have organic earnings growth of 13% year over year. Just simply remarkable. Great chart at DividendCafe.com showing the S&P 500 companies with the most exposure to revenue in China and what that has meant relative to the S&P 500 overall. You can see that that China exposure in the S&P is where the weakness in the S&P is to be found, suggesting that indeed it is very much the trade and tariff issue that is weighing on the market. Quick question for you, for those that say, back to my subject last week about active versus passive investing.

I'm just wondering why, if passive investing is a wave of the future, these ETFs, and there's no more room for active management, I am curious why the passive ETF makers, the stocks and companies engaged in that business, are down so much this year. Interesting, isn't it? I guess it's sort of ironic, and I mean it to be somewhat cute, but I also think there's a profundity in this. Passively speaking, you would think that the market would be weighing it differently. I wonder what we're missing, if the self-fulfilling prophecy is in place. Dollar rally seems to be slowing. I'm going to talk more about the dollar next week. The chart of the week is really worth looking at, dividendcafe.com, that you see what the

actuarial average return assumed in the actuarial assumptions of the state pension funds across the country, 7.79% versus their actual earned return over the last 18 years, and then the funding ratio. And you can see how essentially the pension funds have a perpetual problem of underperforming their own assumptions, even in a nine-year bull market. And then their inability or unwillingness to fund is the source of the continually growing unfunded liability as they continue to kick the can down the road of what the state pensions will end up having to pay. Okay, I'm going to leave it there because if I go through everything else I wrote in DividendCafe.com this week, this podcast will get too long.

So I'm going to encourage you to go to DividendCafe.com. I thank you for listening to this podcast. Check out Advice and Insights for the Financial Crisis add-on. And other than that, I really wish you a wonderful weekend. And I am open to your questions and comments anytime. And we hope you'll subscribe. We hope you tell your friends. We hope you listen every week and all that good stuff. Thanks for listening to The Dividend Cafe.

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