The Dividend Cafe - Practically Dealing with an Expensive Market

Starting point is 00:00:00 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 brought to you from the beautiful Newport Beach studio. My name is David Bonson. I'm the managing partner here at the Bonson Group, where every Friday we attempt to bring you some new investment wisdom, some sort of macroeconomic perspective, and most importantly, a practical takeaway of what it may mean to you, either as a citizen wondering what is happening

Starting point is 00:00:41 in the economic affairs of our country and our world, or more particularly as an investor who desires to see financial markets attached to one's own financial goals, needs, and solutions. The Dividend Cafe a few weeks ago was devoted to a special issue. I've done it now every four years for quite some time around the election. And what has happened out of that issue, which has been very well trafficked, both the video, the podcast listens, and particularly the written version, there's a lot of questions have come in. And I think that when you're addressing a lot of topics around the election that include the politics of it, one's expectation, certain policies that might be important to people, ramifications out of either certain

Starting point is 00:01:33 policies or a broad policy portfolio in just the general direction of what it could mean, whether it's for the economy or the culture at large, the nation. And obviously, not only is there all of these different areas of interest, but in a moment of pretty heightened emotion and passions and opinions, it generates a lot of differing kind of questions or whatnot. It can go in a lot of different directions. And it's hard for me to think I know exactly what people are asking about and try to address those things after the fact. But if any of you want to send in your questions, I'm going to devote next week's Dividend Cafe. We're obviously now into crunch time here before the actual election. I'm going to devote next week's Dividend Cafe entirely to questions related to ramifications of the election,

Starting point is 00:02:30 aftermath of the election, what do I think it'll mean for this or that. Perhaps it's this sector, perhaps it's something specific in international relations. I'm not going to put the ideas in your mind. Email us questions at thebonsongroup.com, questions at thebonsongroup.com, and I will be addressing these things next Friday in the Dividend Cafe. I think any of you watching the video or listening to the podcast probably know that this is my second or third favorite medium by which we deliver this because I am kind of a fan of the written word. And nevertheless, we know the podcast is the most popular way people take in Divinity Cafe. The video, unsurprisingly, is below that with this face made for podcast. But the written is the origin of it. And certainly the written word being what I enjoy doing the most. But also where I think there's the greatest level of reader interaction or consumer interaction in the sense

Starting point is 00:03:27 that the charts and let's put it this way, the most thought I can possibly muster going into the writing. So by all means, take in the Dividend Cafe however you want. Just know that there's these different options and that what I'm doing here in the podcast video is never just reciting the written. I'm almost always, like with maybe two exceptions, I think, ever, I'm generally recording anywhere from a few minutes to a few hours after I finished writing, but I'm not just merely reciting it. I'm redoing it from memory and trying to capture the best takeaways of the dividend cafe I can, but it's always centered around what the written offering is. Okay, enough context and setup. Let's get into it. I have been talking quite a bit. I mean, a lot of people have, but I in particular have

Starting point is 00:04:16 been talking quite a bit around valuations, especially in this period of elevated what's called the market multiple, which is the price to earnings ratio. A multiple being what is the number you get when you divide the earnings into the price to see what people are paying for a given level of profits. And that has historically been measured either by looking backwards, like in the past 12 months, if a stock generated $10 of earnings per share and it's trading at $100, you say it has a trailing multiple, a P ratio of 10, it can be done forward. We're expecting to make $10 and it's trading at 100,, it has a forward multiple. Everybody these days is going off forward multiple because the backward multiples are

Starting point is 00:05:12 especially insane. But on a forward basis, which are not unrealistic. That's one thing I want to say. Even though the forward multiples are obviously riskier than the backward multiple. Why is that? Because the backward multiple has already happened and the forward multiple we believe will happen or hope will happen or think will happen, but it's fallible. But I got to say, forward multiples have been reasonably reliant for quite some time. It's one of the true miracles of American public markets is

Starting point is 00:05:40 the ability of companies to forecast their own profits. They can be wrong. There are disappointments, but it's so rare. And so looking ahead to some form of consensus expectation of profit and applying a multiple to that based on current price, I've been talking all year about how we've been trading at a rather rich level. And right now it sits at 21.8 times, let's call it 22 times next year's profits in the S&P 500. We've averaged something around 16, 16 and a half times going back 30 plus years. Now, when I say we've averaged it, I don't know that there's been a single year that it actually was at that level. An average by definition is a median number, oh, excuse me, a mean number with a lot of numbers above it and below it that equal it mathematically. The longer the period of time goes by, the difference between

Starting point is 00:06:34 the mean and the median, but all we care about here is the average, and that multiple has been somewhere in 16 and a half. I've said it a lot. We've talked about what it means. The most important thing I have felt is that I do not want to be subject to some sort of major revaluation in the sense that we believe we're buying things that are appropriately priced. And as Diven Growth investors, it has a bit of a more value bend. It has more balance sheet strength, which tends to put a lower multiple. When you have a whole bunch of cash on the balance sheet, that's a lot of cash not going to work in productive growing things. You have less leverage, you have less debt, all those things that can drive a higher multiple when everything's good, but of course, risk up the company. And we tend

Starting point is 00:07:22 to like stuff that's a bit more de-risked, not entirely. There needs to be an appropriate amount of risk on a balance sheet, but we want it to be sensible in a way that it does not undermine the ability to grow distributions of cashflow to shareholders. This is an extremely important process to us. It's what I've spent 25 years driving an investment philosophy around, written a book on, built a six plus billion dollar company around, et cetera. Let's hold off on that for a second because I just want to explain something about the market itself.

Starting point is 00:07:55 When I talk about the S&P 500, the main reason I explain this is A, the kind of historical reality of bull markets ending with multi-year periods of consolidation that can have big up periods, big down periods, but over a period of time running in place and really averaging much lower than average returns. And it's not very complicated to understand why. Why would a forward period that starts at a moment of high valuation have lower expected returns? If I have to answer that rhetorical question, I probably have already done something wrong because the setup is meant to be self-explanatory. It's obviously math. However, the nuances around this throughout the year, I've been careful to try to give here in

Starting point is 00:08:40 the Dividend Cafe, that we are really dealing with high valuations that are concentrated as the portion of the market in cap weighted, market capitalization weighted indexes, which is the gazillions of dollars in S&P 500 indexes, have seen the technology and technology adjacent sectors become 40%, 41% of the index. And it used to be much, much lower. It's seen a couple of companies become a massive amount of the index. Seven companies, 10 companies, three companies, two companies, and even just one company become a very disproportionate factor in the index. And when you X those things out, there is a difference between a market that every single sector is pro rata overvalued and that equals an overvalued market. There's a difference between that what we have now, where it is much more of certain sectors that are high weightings that are tremendously overvalued relative to history and then other sectors that are evenly valued.

Starting point is 00:09:46 A little bit that may seem cheap or cheaper, a lot that seems modest, moderate, fair value, whatever you want to call it, and then others that are over. But we're not cap-weighted investors at our company. And the reason I'm writing about it this week, if you are a client, ignore this for a second or understand I'm not talking to you because for people who are clients of our firm,

Starting point is 00:10:08 this isn't an issue. We're not index investors. But I want to make something very, very clear. For those who are not clients, I'm not saying you ought to go out and sell your S&P 500. It's very possible you should, but that's not what I'm saying. What I'm saying is if you're a buy and hold strategic allocator, you think you have the right blend of a portfolio and that you accept the inevitable periods of undervaluation, overvaluation, volatility, and periods of subpar returns and over average returns and what that will mean long-term and wish to be out of the guesswork of timing and valuation and all that. That's what you sign up for. And I'm not sure I would be doing anything different, but

Starting point is 00:10:56 that pretty suppose that somebody told you or that you know what it is you bought and why, and that you know if you bought it recently, what it is, or if you bought it a long time ago, you know how it's changed. That you didn't used to have two companies equal 12% of the index, or I don't have the exact math in front of me, but I do know that the top weighted side, one company being six or 7%, seven companies being the MAG-7 being 20%, now higher than that. There is a top heaviness that's different and very possibly different than what you thought you were buying at the time. That may be fine. And it also may be that you don't even want to know what it is. You just believe in a long-term buy and hold strategic allocation. I don't recommend people let their fear of valuation get in the way of

Starting point is 00:11:45 what their plan was. I just want them to know what their plan was. That's all. For my company and the way we think about equity investing, we believe the point of holding publicly traded stocks is to own a right on future cash flows and that we want those future cash flows the company generates to represent future cashflows to us. That's what we call dividends. That's our investment philosophy. So if someone doesn't have that philosophy and accepts buying things that are higher priced and there will be a valuation, it does not mean higher priced is that now you face an inevitable crash the next year because overpriced things get more overpriced all the time. And sometimes they correct quickly and violently. There's a lot

Starting point is 00:12:33 of that in history. Other times it's a slow burn and a muted return and an extended period of consolidation. There's any number of things that can happen out of this situation. And I don't have any forecast as to what it will be. I believe it will be a subpar result to what we're doing. That's not anything I'd base a decision around. It's my belief that you are generating a return from something over time that is going to be more volatile, less predictable, and just different than a lot of people signed up for. So I think for a lot of folks dealing with the overvaluation of top heavy markets, what they ought to do is nothing. For a lot of people, they may want to say, oh, I did not know this is what it was or things have changed. Because the circumstances have changed, I think a change

Starting point is 00:13:26 may be in order. I'd like to talk to my advisor. I'd like to sit down with my spouse or talk to a different advisor, whatever the case is, and map out a proper plan. And then I think third, there is entirely the possibility of viewing it from a fully different paradigm, which is still going to be driven by investor behavior, still going to be driven by discipline, still going to be driven by fundamentals, by not thinking one can time the market, know when overvaluation corrects, know when undervaluation rallies, essentially is operating within a belief that stocks are companies. And then I'm not trying to generate the return of an amorphous 500 stock basket, but rather businesses that have more than one so that they're not concentrated. There's a diversification both of company and sector,

Starting point is 00:14:21 both bottom up and top down diversification. But then again, it's centered around this cashflow generation where there's an appetite to return cashflow to me. And that gets to the heart of dividend growth investing. I hope that makes sense. Here's what I think is going on right now. A lot of people are looking at the valuation thing saying, oh no, stocks are overvalued. And let's be very clear, a bunch of stocks are. That either means something to you or it doesn't in terms of actionable investment decisions based on the things I said the last five to 10 minutes. High yield bonds are trading 2.9% better yield than treasuries. A bunch of S&P 500 companies cost less to insure their debt than it does the United States government.

Starting point is 00:15:07 Credit spreads are very tight. A lot of spread instruments, meaning debt that trades at a spread to treasuries, is not what we call boring bonds, but it's credit sensitive. In structured credit, in mortgages, in corporate debt, in bank loans, a lot of these things are very stretched in valuation too. We have to be valuation sensitive across every asset class. If people don't think real estate is over value relative to historical valuations, I got a bridge to sell you quite literally, actually. So please call me. I'll sell you my bridge. I mean, this is maybe fine. Real estate does do

Starting point is 00:15:44 a far better job than stocks and bonds do at allowing people to lie to themselves about the overvaluation. But no, there's overvaluation in a lot of asset classes right now. The key is what to do about it. And then the key is separating that discussion of valuation from another V word, volatility. I couldn't care less about high valuation because of volatility. It's fascinating to me. The market's doing incredibly well. It's been doing very well all of this year with a couple of tiny exceptions that were child's play. A single digit market volatility doesn't even count. It did very well last year.

Starting point is 00:16:22 Markets have been on a tear. Multiples of expanded earnings have grown. Volatility, though, is not really low right now if you measure it by the VIX, by fear index, by how people pay for protection. The VIX is sitting around 19. It had been between 12, 13, 14 a lot of this year. That was very low, way too low. lot of this year. That was very low, way too low. But regardless of what the volatility has been, I just don't think about these things as, oh no, be careful of valuation because it could lead to volatility, meaning up and down movements. Volatility is a reality of liquid risk assets because they're liquid. And there's a lot of people in the world that operate off emotions, they're going to be buying and selling more, and it's going to exacerbate

Starting point is 00:17:09 up and down movements. And liquidity becomes a big issue. Sentiment becomes a big issue. Perception of macroeconomic conditions becomes an issue. And I love volatility because it enables me to make money for me and my clients off of other people's bad decision making. But I do not fear volatility because, well, this is this really bad thing that happens. Volatility means up and down, but things going down and staying down and staying dead forever. I can give you examples from the 1990s, but I can give you examples from the 80s, the 70s when I was a younger lad. And I can give you examples from last month, last year, last five years. And I promise there's more coming. Some of them are going to a

Starting point is 00:18:05 graveyard. Some are just going from a brutally high valuation to a much lower and then staying there forever, even as a very viable company. I've talked a lot about the things bought at their peak in the late 90s and then how they've just performed extremely well since, but their stocks are down a ton. There's all kinds of bad things that can happen. That's my fear, not volatility. So if someone's saying, okay, wow, David's worried about valuation. He has a different investment philosophy at the Bonson Group and it's free from volatility. No, it's not. I think there's lower volatility. I just don't care. I care about the solvency and the extended period of muted returns that comes from buying overvalued assets. And I would like to find a system of investing that neutralizes that. And

Starting point is 00:18:52 I believe we've done so. So that's the difference here in the lay of the land right now. We'll unpack this more weeks, months, years to come. There are a few other things here at DividendCafe.com this week about government debt. The chart of the week is very fascinating, showing scatterplot of average returns around different valuations going forward and what it could mean. Now, the funny, I mentioned this before, the average return out of the S&P at 22 times going forward three years is a couple percent a year. but the average came about because of some that were higher and some were a lot lower.

Starting point is 00:19:29 And you can look at the chart. I hope you will. That's it for this week. Questions at thebonsongroup.com for next week's special question election issue, as we are now less than three weeks away from that day in November that we're all waiting for these campaign ads to stop,

Starting point is 00:19:46 for the misery to stop. Thanks for listening. Thanks for watching. And thank you for reading The Dividend Cafe. 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 Thank you. of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice. The Bonser Group and Hightower shall not in any way be liable for claims and make no express

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The Dividend Cafe - Practically Dealing with an Expensive Market

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