The Dividend Cafe - Replay - National Conference Call on Market Outlook July 27, 2020

Episode Date: July 27, 2020

This is the replay of the Market Outlook National Video Call with David L. Bahnsen and Scott Gamm from July 27, 2020. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, thank you, Erica, and looking forward to our talk here today, Scott, as always. And thanks to all of you who have taken this summer day to join us once again. I've lost count now how many, I think we're at seven or eight, but we're doing these bi-weekly as a means of just keeping current with various things happening in the markets, various things on your mind as we continue through not only this COVID moment, but the economic moment and what will soon become a bit more diversified as far as what is topical, primarily the election season. So I don't see any reason to stop these biweekly calls,

even when COVID is not front and center on everyone's mind. I think there's going to be plenty of issues, challenges, and opportunities for conversation as it pertains to market positioning for investors for quite some time. I'm going to turn it over to our host, Scott Gamm, who has once again been kind enough to join us and engage in what will hopefully be a thoughtful dialogue. So, Scott, I'll turn it over to you, my friend. Well, David, thank you, as always, and great to be with you for another one of these calls. And, you know, we've been talking about the markets rally really since March, but you mentioned the start of us doing these conference calls. And I think the market has been up really after each one of these calls.

And we've been doing these calls for a good two or three months so far. So I always like to start out, David, with just kind of your broader temperature on the market. We've got earnings season continuing to move through. Obviously, this week is going to be a really important week for earnings with all the big FANG names reporting on Thursday. But how would you characterize things right now? Well, there's sort of two themes right now on a day-to-day basis that I'm watching in

the markets. day-to-day basis that I'm watching in the markets. One is the issue of the average stock in the market versus the overall market indices. Because I think those are two very different conversations. We've had periods since March where the overall market index seemed to be doing fine, but the average stock in the market was not. And people could say, how is that possible? It doesn't make sense. And those were periods where four or five big tech names that happened to, in a couple of cases, be over trillion dollar companies, and in all cases, be hundreds of billion dollar companies, that their vertical ascent was largely carrying the market. Then we've had other periods where those stocks were either flatlined or even declining, as is the case in the last couple of weeks. But the rest of

the market was seeing a much broader, what we call breadth, market breadth that was driving the market. Those are healthier markets when you have a broader participation. So that subject right now is, I think, very important because there are two schools of thought around what will happen if, and I would say not when, big tech rolls over. And that is that it would bring the whole market down with it. The market's been reliant on its leadership for some time, and therefore it would compress valuations, compress sentiment across the overall stock market and bring down other sectors with it. That would be actually, believe it or not, the exception to the rule.

Historically, you have not seen a leadership sector fall and bring everything down with it as much as you've seen what we call sector rotation, that leadership is transitioned from one group to the next. I think that the healthier the market is when that happens, the better to kind of assert some ongoing market presence. And that will require something broader in terms of how markets are performing, cannot be relying on four or five or six big technology names. So that's sort of theme number one. Theme number two, I've been writing about a lot, and that's the U.S. dollar. And I think this is a profoundly important subject because it's not tactical, it's not transitory, it's not a trade, we're not

currency traders, but you've had a really overvalued U.S. dollar for quite some time. And it's always hard to use terms like overvalued, undervalued, or the currency. But you have to use relative valuation metrics against historical ratios. And the weakness that has been embedded in global economies has just created a stronger U.S. dollar. And it's stayed elevated, even as our Fed has just poured on excessive accommodation that would otherwise generally bring down the value of the dollar. The dollar has now broken through some support levels, down over 5% on the year. And even though there's plenty of things you could use to talk down euro and yen and other global developed market currencies, it's the U.S. central bank that is most accommodative right now around monetary and fiscal policy deficit.

Remember, if you're running a huge deficit in Japan and you push it up 10%, that's much different than running a lower deficit in the US and pushing it up 30%. And so the trajectory of where we're headed with our deficits and so forth, I think is putting a lot of downward pressure on the US dollar and it's doing so from a position where it was already overvalued. Why do I say that's profound? What is the average listener right now care? It reprices emerging markets. It reprices commodities. You know, oil, for example, is denominated in dollars. Weaker dollar pushes oil prices higher. There's things like that that I believe are important for us to understand in our investment positioning into the later part of 2020 and going into 2021. Well, and that's a lot to unpack and great stuff. And I have a lot of questions actually on the

first part of your answer about tech stocks. But I do want to follow up, though, about the dollar, because it's also causing, in part, this surge in gold prices, which are at a record high today. I'm curious how you think about gold in a portfolio and if you have any broader reactions to the surge in gold prices, because some people might be surprised to see gold at record highs and the S&P 500, a stone's throw away from record highs. Yeah, and I don't blame anyone for being surprised at that. But I will try to correct the record historically, because believe me, the record had to be clarified for me historically as well over the years. This has been a 25-year education on my part. I am totally bought into

the idea that right now, part of gold's move higher is related to the dollar's move lower. But the understanding that gold and the dollar are always and forever inverse correlated does not stand up to the historical record. There are ample periods of time in which they're not correlated at all, let alone inversely correlated, or may even be positively correlated. And that's where a lot of more sophisticated gold investors have come to say, gold is not necessarily something you buy to defend against a weaker dollar or defend against inflation. It's something you buy to defend against generic, broad central bank dysfunction.

against generic, broad central bank dysfunction. The reason why I don't see gold as being particularly effective at doing that is we are right now getting back to the place gold was eight or nine years ago. And I think we've lived through the most unbelievable eight or nine years of central bank dysfunction ever. So in those periods in which gold has been supposed to do something big and it hasn't done it, that can represent a pretty big disappointment in the defensive aspects of a portfolio. But I definitely think in this moment right now, there are people for those right reasons going into gold, seeing it as a defensive play against dollar and central bank and other type things. The problem is that the lack of rhyme or reason, you mentioned even gold going up with S&P going up. And in theory, I've had reporters frequently, Scott, say to me, how could stocks

be going up and gold going up at the same time? But of course, that's happened in 50% of the time over the last 50 years. Gold is definitely not inverse correlated to the stock market, nor is it positively correlated. It's just not correlated. Gold does what it does. And I've never found anyone that can figure out why that is and when it's going to be doing what and so forth. There's a lot of central bank buying, particularly in countries like India, that can heavily affect the price of gold. I don't think very many American investors sign up for an investment policy that is going to largely be driven by what an Indian central bank is doing. And I also think it's highly

temperamental. There's a lot of speculators in the space. So most of the reasons that people end up investing in gold, I think are more fiction than fact. And that doesn't mean that they can't have really good trading opportunities along the way, but we don't trade, we don't speculate, and therefore we don't see gold as having a real viable place in our client portfolios. And to your point on just gold versus stocks, I mean, you could, and maybe you do right now, have a situation where an investor can make a bullish bet on the stock market and a bullish bet on gold as a hedge, right? To kind of play both sides of the coin because there is so much uncertainty out there.

Right, and that's an example where you could win twice. You could win with stocks and then have your hedge not work out and say, well, that's okay, that's why I bought it. But I also think that's a place where you could lose twice. You could have gold drop and stocks drop. And I go back to the March moment where gold wasn't crashing, but it wasn't going higher. And people are saying, I'm surprised it isn't going higher.

Those points in time, and 2008, by the way, is an incredible example. Those points in time at which you most want a hedge are when you are least likely to get it because those things like gold, like sometimes even high quality municipal bonds, whatever it may be that they're to diversify a portfolio in the heat of battle, the correlation goes to one and everything becomes positively correlated. And if everyone's having to sell those things to get to cash, unless we one day go to an unlevered financial system, which is never going to happen. As long as we live in a levered financial system, there'll be people that need

to access cash in moments of market distress, and then those hedges fail to operate that way. So a long gold, long stock pairing right now could win twice, it could win once, and it could lose twice. And you mentioned central banks once, and it could lose twice. And you mentioned central banks earlier, and we actually have a question coming in from a viewer. What is the likelihood, in your opinion, that in the next two or three years, the Fed reverses course and raises interest rates to combat inflation? Pretty interesting question. And of course, we have a Fed meeting this week where we'll hear from Jerome Powell. And is the question next few years? In the next two or three years? I would say in the next two years, it's as close to 0% of chance as I can come up with without using the number zero.

The other source I have for that is the Fed themselves that has basically told you they won't be raising rates in the next 2% and provided their own dot plots to that effect. In the next three years, my personal opinion is it's still very close to 0%, but the Fed hasn't technically said that. And so I can only go off of history. I can only go off of history. And we went to zero interest rate policy under then Chairman Ben Bernanke in October of 2008. And the very first interest rate increase took place in the fourth quarter 2015. So it was over seven years. And then that one didn't really count because it was just a little kind of sort of quarter point. And then they were going to raise rates four times the next year,

and they didn't do it, which by the way, it was an election year. And they didn't raise rates again for another year. So by the time they really started raising rates off the zero band, bound, it was eight years. Japan, it's decades. We are in an environment of incredible philosophy towards monetary accommodation, a belief system that it's necessary and that it is effective. So I can't say never, but my belief is that we are looking at a zero bound for a very long time. And so with that, David, we were talking about different sectors at the top of our discussion here. We talked about tech, but it's interesting because last week in Dividend Cafe, you sort of reiterated your views on your dividend growth philosophy. And I always think that's worth you repeating right now. And for

those interested in more on your thoughts on that, I encourage them to look at your book from a few years ago, where you pretty coherently detailed everything you know about dividend stocks. Yeah. Yeah. I mean, everything I believe about dividend stocks, and that was sort of what I was wanting to, as you mentioned, rehash in the dividend cafe last Friday. I think that it's dangerous for me to ever give the impression that we believe in dividend growth investing tactically or in a particular season, as opposed to as the almost worldview of investing, something that we think is very evergreen, view of investing, something that we think is very evergreen, that at various periods of deflationary pressures, inflationary pressures, bull market, bear market, it's a very all-weather belief system about investing. And if it weren't, it wouldn't be my belief system about investing.

If I thought that during one season of time, I should be doing dividend growth, but another season of time, I should switch it all up and try something totally different, then my philosophy would change to that sort of wild, tactical, and I would argue speculative framework. So in the current moment, most people are more concerned with defense than offense. Most people are concerned about the uncertainty of the moment and curious about what happens to corporate profits, what happens to just macro economic strength, and what this means to the stock market, and what this means, of course, to their portfolio. And whether that is an uncertainty that lasts for three months, six months, or over a year, it's very tricky. I think most people are pretty humble about this, at least in my client base.

I haven't seen a lot of people go out to where the media goes of trying to treat this like it's normal recession. I think most people understand that it didn't have a normal recessionary beginning and therefore is unlikely to have a normal recessionary end. A lot of the cyclicalities that normally are a part of a recession don't necessarily apply here. And yet there's just a lot of uncertainty. And so my view is that dividend growth investing is a very healthy way to deal with uncertainty. Because first of all, an awful lot of investors need current cash flow.

And I don't know where they're going to go get it. The uncertainty of trying to sell stocks at opportune times is probably the worst thing on the planet anybody could do for a monetization of recurring cash flows. Certainly one of the riskiest, it could work out, but it would be hard to imagine doing something much riskier. And then of course, going to some of the traditional sources of recurring cash flow, such as the high quality bond markets, treasuries, AAAs, investment grades, things like that, they don't pay you anymore, as we know. And so dividend growth represents a really sensible place to get consistent cash flow for withdrawers of capital.

And my argument is for those who are looking to accumulate capital, but do so with some sensitivity to volatility and some sensitivity to macroeconomic risk, that dividend growth constrains itself to a higher quality aspect of capital markets, where there's stronger balance sheets, where there's less indebtedness and leverage risk, where there's more non-cyclical business models and stability. So there's still price risk. There's still the impact of sentiment that comes in and affects PE ratios and move stocks up and down. But all things being equal, it provides a bit more stability and uncertainty. And history has borne that out decade after decade after decade. And then people say, yeah, but what do I have to give

up to get it? And my argument's always been, you don't have to give something up. That over the period of time that this lasts, that compounding of dividends is really incredibly profitable. And no one's ever going to do it. But if people understood it at a deep level mathematically and economically, they would be rooting for their portfolio to constantly be going through hyper volatility because it would be so unbelievably attractive to them, the kind of capital they can accumulate by rooting for that distress because of the reinvestment of dividends and so forth. So that's a lot of what I was rehashing in Dividend Cafe Friday. In the current moment right now, I believe in it as I always have

and I'm very grateful for the fact that we see in our own portfolio the resilience, the management alignment that we want, and the financial metrics necessary to persist this way. Well, and that's such a great point. I think that the whole dividend discussion is timely now because, you know, we talked about zero interest rates or low interest rates earlier, and we talked about these surging tech stocks. So I think it's important to have the dividend discussion with those other two big themes in the backdrop, because it can kind of, I wonder if it could kind of distract you, not you, but just people in general from the whole dividend discussion, if you've got these high-flying tech stocks on one hand, and then you look at some of the more stable dividend growers on the other hand? Like, how do you grapple between the two?

Well, and this is the thing that I'm grateful for as someone who was taught, not by my late father, but also by some really great teachers in my life, that history is there not just to teach us about the past, but to guide us into the future. And I believe with every ounce of breath in my body what John Kennedy said about a knowledge of the past prepares us for the crisis of the present and the challenge of the future. I love that quote. And Scott, it's uncanny that what you're asking is not just an opportunity to learn from history indirectly, which is often available to us in markets, things that are not totally similar, but provide some precedent and some historical lesson. We're even talking about the same sector in that there was a period of time that happened

to be exactly 21 years ago, let's call it, in which technology was exorbitantly overpriced and dividend stocks appeared to be coming at a very high opportunity cost. Because when ABC.com was going from $10 to $100 and you were in your boring dividend growing company that had been around a few decades and had a bunch of cash on the balance sheet, that you were missing out on those opportunities. And so there are a few differences now. It's not an entire sector of worthless.com companies. It is four or five companies that are anything but worthless. They're some of the greatest, most powerful companies in history. But on a valuation basis and in that relative story, we're being asked to re-believe some things that 20 years ago, I think we decided to unbelieve them, if you follow

what I'm saying. And so for me, I don't feel a temptation to believe that this time it's different. I don't feel a temptation to believe that four or five companies are going to be the only investable space on earth and that I will pay 300 times earnings, you know, to get there. I certainly believe though that they can go higher in price. I believe that as long as there are more people putting more capital into them, that price can get pushed higher. And if one's investment objective is to try to squeeze as much juice out of that fruit as they can and kind of follow a momentum trend that way, that's a different investment criteria than I have. And so I can't really speak to when that party may end. My investment objective is to preserve capital and get the best return I can within a particular risk appetite

and do so as a fundamentalist, do so around the value of a company, the discounted value of its future cash flows. So when I look to some of these really big tech companies that I think are tremendous organizations, I see the biggest fear, which is exorbitant valuation. But then I do see extrinsic threats to what we currently think are really defensible business models. To be quite candid, what is great about these companies is that they're legal monopolies. And I don't mean that pejoratively. I would defend their right. Like if Congress were to go attack them for being a monopoly, I would argue that they're not. But I mean, functionally, they have an incredible ability to dominate spheres of e-commerce and of mobile technologies and of software, cloud, and of search and so

forth. The monetization of digital ad space, social media, you get what I'm saying, right? So the question is, what could be a catalyst to breaking up this kind of environment we're in? I think it's government activity. I think it could be very bipartisan right now that could end that party. But then really history tells me I don't have to know what the catalyst will be. history tells me, I don't have to know what the catalyst will be. The catalyst generally is that it just gets too overpriced and there's more sellers than buyers and then look out below. The difference this time versus 1999 going into March of 2000 when the NASDAQ crashed, the NASDAQ went down 70% and stayed down for 15 years. Okay? The difference this time is that there are trillions of dollars of index funds that will have to be selling as it goes down as well.

So there's, I think, even more embedded risk systemically than there would have been 20 years ago. Wow. And David, you also seem to like small cap companies right now, but I guess you could really argue that the pandemic is hitting small cap stocks more than large cap stocks. So would it be good for you to explain your thinking on those two areas of the market? Yeah, you're smart, Scott, because that is an apparent contradiction in my thinking here, except for I'll be able to clarify why it's not. In theory, I think in a period of uncertainty and macroeconomic distress

and everything that's happening with the pandemic, you want better balance sheets, which is large cap, not small cap, and you want more dependable cash flows, which is large cap, not small cap, as a general rule. But what I would be defending or presenting as an opportunity is not small cap in any indexed or broad or macro sense. I would be defending very selective and actively managed small cap. If people want to email us to ask who we use in that space, we don't manage small cap in-house in the bonds group. We use an outside manager because we are in-house efforts and our investment

committee are solely focused on portfolio construction and dividend growth and around small cap type companies. I think it's a different mentality. It's a different investment objective. And so we go to third party experts in that space. But I would argue that both things are true at once. There's a better opportunity. There's no way the market is caught up to some of the better $1 to $5 billion or $1 to $8 billion companies, small and mid cap size that are out there. that are out there. And yet, buying the index, you're going to be buying something in the range of 30% to 45% junk. Really dangerous companies that are right now highly vulnerable in this COVID pandemic and this economic distress moment. And so my preference is on profitability. preferences on profitability. And I think active selection is incredibly important in the small cap equity asset class. All right, David, I want to shift a little bit away from equities and talk

about structured credit. This is something you've been talking a lot about. Explain sort of the view you have on structured credit in terms of whether or not you think there's value there. And then also arising mortgage delinquencies and commercial mortgage defaults, a threat to some of your views on structured credit. Yeah. So there essentially exists this asset class that has come about as a result of highly sophisticated securitizations over the last couple of decades in which pools of cash flow, underlying assets like a mortgage can be pooled together and generate a stream of cash flow to an investor and it gets securitized into an investable asset. And this can be done with commercial mortgage-backed securities. It can be done with residential. There's different categories of both. And it can even be done with what we call asset-backed securities

that are backed by pools of car loans, student loans, credit card receivables, all sorts of things. And it's not esoteric and it's not crazy. It's actually an incredibly efficient market. It's a balance sheet, right? You have a certain asset and a liability that gets aligned and it has a totem pole of claim on the cash flows. And so you can kind of measure some of the risk and so forth around it. But it's not as widely held as treasury bonds. It's not as widely held as all the stocks that are on my screen. And so there are periods, we went through it in March

and we went through it in 2008, where the liquidity evaporates. The heavy buying and selling of it goes away. And I learned in 2009, in the aftermath of the financial crisis, the incredible amount of money that can be made at a much lower risk profile from those who can kind of patiently await a sort of resumption of full value in the structured credit space, because you have pretty money good assets that fundamentally have a lot of equity in them, right? The equity person in a commercial property, see everyone talks about commercial real estate problems and then they talk about CMBS and they think they're talking about the same thing. They don't understand that that problem in commercial real estate could very well be an

opportunity for the mortgage holder because they're at the top of the totem pole. The equity person down low, they may end up losing money on it. Property may get foreclosed on. It may get sold. There may be losses. But on the bondholder, those things flow up and there's different tiers of what they call trenches of security. But my point being, there is a real method to this madness and it's pretty sophisticated investors that are largely involved in it. And my belief is that whenever you get something distressed because of illiquidity

and not because of solvency, there's an incredible opportunity to make money, but you have to be patient and you have to worry less about the print of a price on your screen or on your paper, and more on just these fundamentals playing themselves out over time. Well, the Fed made it kind of easy this time. Because for a lot of residential mortgage-backed securities, a lot of syndicated loans, and a lot of asset-backed securities of higher credit quality. They created this vehicle called TALF 2.0. It was the term asset-backed security facility. They did one in 2009 as well. And stuff that was trading 80 cents on the dollar was bid back up almost to a dollar pretty quickly. And they let a lot of the big Wall Street banks

come in and create funds to buy these assets that had full Fed backing and they could leverage them up three or five times or whatnot. So there's a lot of free money that could be made there. So a lot of those structured credit things have played out, but there's still some that don't have direct Fed support and they're still trading at a discount to par value.

So will there be challenges along the way? Will there be some price volatility? I would certainly assume so, but are there big spreads available in the coupon, the cashflow that investor will get, and eventually price appreciation in some of these aspects of securitized credit? My belief is there will be.

It's not for everybody. Some of the stuff I just said put people to sleep. Some of it confused people. But where there is an understanding, at least a modest understanding, and where there is an appetite for such risk, I think that it's a diversified way to go get high single digit and low teen returns, even at these levels, without taking on excessive amounts of risk. So I remain of the belief that structured credit still offers opportunity. And I believe that what the challenge is, is to make sure people are preying off of where there's been illiquidity, not where there's been insolvency. Okay. Well said, David. And as we wrap up here, we got a couple more topics to touch on. Somebody writing in wanting to know your views on the emerging market space right now,

and if you think that would be an overweight area of a portfolio right now. I do. I just would really caution people similar to small cap to not go into emerging markets in an index. I think that the emerging markets as an index are primarily very over-weighted to China. They're shockingly over-weighted to technology. It used to be that they were big materials and commodity type plays. They're even more so now, almost like Chinese dot com type companies. But I think that you have very low P.E. ratios in a lot of the emerging markets where there's very high growth rates and you should technically get the tail end of a weakening U.S. dollar. The central banks have room to continue to operate. The dollar shortages that have hurt a lot of countries that have a lot of dollar denominated debt have largely gone away. The Fed has opened up swap lines that are simply unfathomable to create adequate dollar liquidity. So some of those

macro concerns are not there. Now, someone could come back and go, well, yeah, but there's geopolitical concerns in XYZ country in Southeast Asia or South America, to which I say, you're absolutely right. That's why it's emerging market. That's why there's a premium that one is trying to get. If you want exposure emerging markets without geopolitical risk or without currency risk, it doesn't exist. But I think that emerging markets is something that people are going to be very rewarded for going into in the right way and with the right timeline in mind right now. All right.

And David, I think we'll end with your thoughts on the market impact from the presidential election. We're two weeks closer to the election than our call two weeks ago. So I'm curious if you have any updated views on kind of how investors should be watching all the polls and just, you know, the implications around the election. Yeah, I'm not sure if that's coming straight from you or from another person who emailed in. I get an email like that at least two to three times a day, and I totally get it, and I think that it's really normal, very common, and I also understand why it may feel like it's even more so this time, based on some of the rhetoric and so forth that has come out, particularly from the more left party in our country over the last several months and through the primary season that they went

through pre-COVID. However, my view is that a really holistic framework is needed to understand investing around an election and investing around a political situation. And most of the people listening right now are very well aware of what my own political inclinations and worldview is, and may be surprised and sometimes even disappointed that I don't take more extreme views around either believing that when politicians I like are in office, everything's going to be wonderful. And when politicians I don't like are going to be office, everything's going to be terrible. But I think that clients should appreciate the fact that I don't take such a simplistic view because that simplistic view has been wrong 100% of the time for the last

80, 90 years. The fact of the matter is that markets have an uncanny ability to not care about our politics. Now, what markets do care about are, of course, the fundamental tenets of free enterprise. And I think that there is a lot of risk that exists right now in our culture. But I am working on a white paper. I've been working on the research behind it for a couple weeks. I plan to have it done in early August August that I want to lay out a whole framework as to how things could look in this scenario, this scenario, this scenario. It's not two scenarios. It's not Biden versus Trump. It's Biden with an overwhelming Democrat Senate majority versus Biden with a Republican majority in the Senate, Biden versus a small majority, Trump winning.

There's so many ways it could play out. And the nature of the separation of powers in the United States and co-equal branches of government makes it very difficult to ever formulate investment policy only on the White House. And so I understand there's a lot of impatience and a lot of anxiety. I don't mean impatience in a negative way, but I just mean it descriptively around where we're headed to think about portfolio management in context of where November will go. But I intend

to do it thoroughly, exhaustively, and diligently. And I'm going to be organizing all those thoughts and various scenarios in the weeks ahead. Well, and we look forward to that, David, and we thank you for your time today and all your insights. And that wraps up our conversation for today, but we'll be back, of course, in another couple of weeks. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC,

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