The Dividend Cafe - Reincarnated as the Bond Market

Episode Date: February 23, 2018

This week, David L. Bahnsen discusses the whole new role that bonds are playing in the market. Topics discussed: It's the bond market, genius Is a capex boom being missed? Be careful about what is supposed to be obvious Links mentioned in this episode: www.DividendCafe.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson, founder, managing partner, and chief investment officer of the Bonson Group, bringing you our weekly Dividend Cafe message. This week, reincarnated as the bond market. If memory serves, it was former Bill Clinton advisor James Carville who once said that when he died, he wanted to be reincarnated as the bond market in his next life, because that's where the real power was. There's actually another famous quote from Carville I'll reference in a moment, but you know Carville was not wrong about the power of the bond market.

As you will see and hear and understand in our ongoing commentary about everything happening right now in the market, investors who are curious about the present lay of the land will be wise to understand how much that is currently going on is really a story of the bond market finding its own footing and what that all means. I think it is a very informative message this week at Dividend Cafe, informative message this week at Dividend Cafe. And I understand a lot of attention is being paid in the media to different news events. But I will tell you, a lot of attention is being paid by yours truly right now to macroeconomic aspects that are impacting our client portfolios.

February has been a fascinating case study in various investment principles, and we're navigating the waters of capital markets each and every day diligently and studiously. But with all that said, let's get into it. The bond market. I titled this little section in the writing, it's the bond market genius. You know, James Carville also famously said once, it's the economy stupid. But since I teach my kids not to say stupid, I won't violate my own parental instruction. So when I say it's the bond market genius, I'm really just trying to grab your attention to reiterate a very obvious point right now. The bond market has taken over. The daily moves in stocks, the primary conversation economically, and the most significant barometer of global economic realities all can be best traced with the bond market, the great discounter of risk, inflation, deflation, and expected growth.

of risk, inflation, deflation, and expected growth. The story of 2017 was that stocks said growth was coming and bonds did not believe it. The story of 2018 so far has been stocks proving that growth is coming and bonds now saying, okay, yeah, you're right, but we hope it isn't inflationary. So yes, the bond market repricing continues. And to the extent that growth in the economy and corporate profits continue, we believe stocks will come out fine. And to the extent that productive growth trumps monetary inflation, which is our view, that productive growth trumps monetary inflation, which is our view, bond yields will likely find a ceiling one of these days. Bond market awakening. Is the U.S. bond market in a giant bubble? It should go without saying for anyone who understands the math of bonds that if the 10-year treasury yield were to go from 2.85% to 5%, the answer would be yes. At 2.85%, bonds were in a bubble.

Prices of bonds go down as yields go up, and vice versa. So essentially, whenever you hear the argument about a bond bubble, it's basically a market call that bond yields are about to explode higher. So what do we make of the argument that bonds are in a bubble? We have, after all, said for quite some time that there is not a great risk-reward trade-off in the bond market. We've held a modest underweight in the asset class and still do, and most importantly, generally see the reason for bond ownership as purely related to being a diversifier and a risk mitigator more than a source of aggressive return. But is that the same thing as saying we're in a bond bubble? One of the things that must be said is that the vast, vast majority of so-called bond bearers

preaching the bubble theory have themselves spent virtually all of the last decade being wrong on the bond market. It is not really a criticism per se. The bond market has been very easy to be wrong about in a world of interventionist monetary policy. But it is still important from a grain of salt standpoint to recognize that the great pundits of our age are not playing off of a wonderful track record. Be that as it may, there is little basis to argue that bond yields in the treasury market are in a bubble, unless one means that current levels of

yield are substantially low. We think it is possible they will prove to be a bit low or even fairly valued, but not substantially low. High-grade muni bond yields and corporate bond yields are more expensive in relative value, making frothy a better word than bubble. We land at the same place we started in this discussion. Bonds are a necessary evil in a portfolio right now, unlikely to offer great returns and potentially even exposed to some price risk if yields advance, but needed in an asset allocation to mitigate the risk of complete stock exposure and fundamental to the discipline of asset allocation in portfolio construction. Is a CapEx boom being missed? Until the market disruptions of early February, I had intended to write a piece on how,

through all of the discussion of expanding corporate profits out of tax reform, all the discussion of foreign profit repatriation, and all the discussion of where excess cash flow may get spent in a post-tax reform world, that there was a potential market event shaping up that had the risk of being substantially missed. The disruptions of early February took center stage. And as we write this week, and I speak right now, the real driver of markets until more clarity and stability take hold is the bond market. But with that said, I continue to believe there is a capital expenditures boom underway that has profound and has potential to have truly profound implications in the marketplace. Why does this matter? Spending on CapEx has been substantially low since the financial crisis and represents the biggest gap in pre-crisis financial metrics that has held economic growth down. metrics that has held economic growth down. Is this story connected to our theme of inflation this week? You bet it is. There is nothing that mutes the inflationary impact of growth like

increased productivity, and there is nothing that increases productivity like capex spending. I believe there is significant need to increase capacity to replace old inventories and equipment and to update various technologies and systems. On the supply side, this is the right bet in terms of where we are in the business cycle and what we expect from tax reform, most notably from the immediate expensing aspect of tax reform. aspect of tax reform. A capex boom is very possibly an overly optimistic prognosis, but should it happen, investors should not be surprised at the powerful force it represents in the market, not just in terms of improving top-line revenues and profit margins, but in serving as an antidote to inflationary expectations. Upon further examination, expectations. Upon further examination, I believe what I wrote earlier in the month about the technical factors in the market, and we spoke about it on the podcast as well, that led to that particularly high volatility week in early February was exactly correct, that the small spark of a

wage growth number led to a chain of events that put markets in a panic attack. The heavy volume of weak hands in ETFs and mutual funds put selling pressure on markets that led to cascading effects in prices as computer-driven buyers removed their bids. Simple enough. But I will add to the story that the role that short volatility trade played in exacerbating all of it is likely as high as many have written. There have been some decent stories in the press, not decent ones too, about this whole phenomena, but the side effects to horrifically large and reckless trade, mostly through inverted and leveraged exchange traded product, owned by very, very unsophisticated investors being unwound. That was all kerosene on the fire of a panic attack. Worse, it was entirely avoidable by

investors following the simple mantra or the advisors who guide investors, don't buy stupid stuff that serves no purpose in your portfolio. stupid stuff that serves no purpose in your portfolio. Inflation in the eye of the purchaser. Why can inflation be so debated and difficult to measure? Because inflation is by definition the phenomena of aggregate price increases across an economy. The last 15 years has seen such incredible dispersion in price inflation, largely led by the areas of the economy most subsidized by the government, college tuition, health care. It has become very difficult. Varying price movements from apparel to food and beverage have created a lot of dispersion, confusion, disagreement about inflationary realities. Let me say it simpler. Some things

have seen significant price inflation. Some things have seen significant price deflation. It makes an aggregate measurement in what weighting to give to different parts of the economy and what aspects of consumer prices to how you measure it. It makes it very difficult. Let's just politely say that the housing numbers reflected in government CPI data, many people find to be a little unbelievable. So at DividendCafe.com this week, I provided you a chart of each aspect, each component in the Consumer Price Index and what its inflation has been since the turn of the century. And you can evaluate for yourself the complexity in being able to do all this. Other elements at DividendCafe.com, we do have a section updating you on our bullishness on the

post-Brexit state of the United Kingdom. Some incredible, and I'll get into it right now for the podcast listeners a little, but some incredible charts on the reality about how stocks perform in a rising rate environment. Essentially, we went back all the way to 1928 and evaluated years in which rates went higher. And we see an average return for the S&P 500 in those years of 10.6%, a positive return. You take the years of falling rates and the stock market has had an 8.7% average return. So you actually have 2% per year better return for stocks when rates are going up than lower. Now, the reason for this shouldn't be too much of a surprise, because some of those years the rates are going down are the worst forms of recessionary, depressionary, contractionary type years. And if there's one thing markets hate besides inflation, it's radical deflation. And we've seen that time and time again. But the point is, is that you have incredible precedent of rising rate years in which stocks have risen.

And I actually think it should be intuitive. PE ratios expand, it gives more favor to, I don't know, there's a whole lot of plethora. But when you have falling rates, you get PE ratios expanding. When you have rising rates, then it makes a yield, the portion of dividends that stocks pay out that much more important. And of course, at the Monson Group, we are obsessed with growing dividend stocks. And then our chart of the week provides a 30-year history of the bond market, the overall yield. You get to see the ups and downs that have taken place within the context of what textbook, secular bull market, what it means going forward. So thanks for listening to this week's Dividend Cafe podcast. We're elaborating at our Advice and Insights

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