The Dividend Cafe - The Easy Path is Ending

Episode Date: July 19, 2018

This week, [someone], [someone else] and [another person] cover [topic]..... Topics discussed: A Mid-Year Look at the Midstream Sector Why Trump May Not Back Down Not All Inflation is Created Equal Links mentioned in this episode: DividendCafe.com 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 am the Chief Investment Officer, Managing Partner at the Bonson Group. And this is our weekly commentary, trying to give you some of the same kind of, you know, broad flash across the pan, what's going on across the global economic sphere. We do it in our DividendCafe.com writing every week. And this is just the podcast version of the same. It's been a reasonably low

volatility week in the market but it's been a pretty heavy week actually in the news cycle. Corporate earnings announcements have started. It gets really really heavy in the corporate earnings season next week and the week after the two heaviest weeks but nevertheless we've started. We've gotten into that and then you know the don't even get me started on the broad news cycle russia and you know everything else so uh fact of matters the market didn't really care about much any of that this week it was market as at least the time of me recording is up on the week a bit and um we're you know at this point now a good uh 1500 points higher than we were at this point now a good 1,500 points higher than we were at market lows of a couple months back.

But it's just kind of teetering around and so forth and so on. One of the things that I find just fascinating in this market right now, S&P 500 is market cap weighted. The index is constructed and weighted based on the market capitalization of the companies in it. So a company, if there were only two companies in the index and one of them was worth $90 billion and one of them was worth $10 billion, then the index would be nine-tenths the one company and one-tenth the other company. Well, that same math is extrapolated across 500 companies, and that's how the S&P 500 gets weighted and fluctuates. Right now, there are five companies. They happen to be Apple, Amazon, Alphabet, which is Google, Microsoft, and Facebook.

Five companies whose market capitalization combined is 4.1 trillion dollars and then there are the bottom 282 companies in the S&P 500 so a little bit more than half the index the smallest and these are still you know big companies to be in the S&P 500 the smallest 282 companies have a market cap of, you guessed it, $4.1 trillion. So five companies have the same size and impact to the index as 282 companies. You can understand why those companies end up having such a profound impact in a somewhat disproportionate movement for the upside or downside and how that index gets measured these things can be very distortive they can be very misleading they they are what they are okay math is math but it's important to understand them and when you have such a heavy degree of index ownership that means that there's a constant amount of shares that have to be being

bought when things are good and that helps put put a bid under those larger market capitalization companies. But then if there's a whole lot of people selling when things go bad, it means that the impact is disproportionate the other way. So just something to keep in mind. Are we out of the woods in the China trade tariff situation? Well, my own feeling is that there's more negativity to come out of the trade war with China before all is said and done. But I do still at this time expect that the negativity will be essentially limited to enhanced volatility for a season, the type we've been experiencing.

I don't believe it will turn to a material and secular repricing of assets. That's my view for now. Why Trump may not back down yet. Look, there's a chart at dividendcafe.com showing S&P 500 has kind of chugged along. It was pretty much flat in the last couple weeks. It's gone up a little bit since a lot of this trade war stuff with China from earlier in the year began. with China from earlier in the year began.

The Shanghai composite, on the other hand, just think of it sort of as an S&P 500 for China is down 15.7%. So I've always believed that President Trump is deeply affected by what the stock market's doing. And the problem or good thing or however you want to look at it, the fact of the matter is President Trump does not necessarily have to look at the stock market. And I'm sure he's not looking at it the way I am, which is how much more could it be up if this trade war wasn't going on? He can look at it and say that our markets haven't tanked and China's have. There must be some leverage point in here working for me.

in here working for me. And I don't know the president's exact mentality and psychology, but I think it's worth seeing those numbers and extrapolating what certain logic and common sense may call for. A mid-year look at the midstream sector, just a quick refresher. Midstream refers to companies in the energy sector that operate in the middle of the energy process. So upstream companies explore, drill, produce. Downstream companies refine, they market, they go to distribution to end users of oil and gas. So the midstream companies are the bridge between the two. The companies that transport and then store oil and gas from the upstream to the downstream. store oil and gas from the upstream to the downstream. And pipelines are the major constituency in the midstream sector.

And because they're large dividend payers, midstream energy companies are often looked at as highly correlated with utilities. But lately, that correlation has really been deteriorating, which I think is a healthy indication that our sector that we're heavily invested in in the energy gas pipeline world is trading off of more than just interest rates. Entering earnings season, investors are likely looking at individual results, capital positioning, commodity price confidence, distribution coverage. The sector has gone from down roughly 15% on the year to now up on the year, still has a ways to go to be validated by skeptical investors. There's wild card around what individual names might migrate from an MLP tax structure to a more traditional C-corp.

There's both positives and negatives in doing that. This week, the FERC gave their final ruling on some tax aspects of how the new tax bill impacts pass-through entities like MLPs. And the final ruling was much more favorable to the natural gas pipeline space than had been telegraphed in March, which is why we got a big rally in MLPs on Thursday. But overall, patience is rewarded in life and investing. And we believe this great income MLP investors have been getting the last couple of years, even with frustration around the stock price themselves, we think will end up being rewarded. Not all inflation is created equal. There exists many orthodoxies around the subject of inflation, not the least of which is that commodity prices in gold go higher when inflation does. But we put a chart at DividendCafe.com this week, courtesy of our friends at Vanguard,

from a white paper they did on the subject, indicating that analysis contains a different dangerous pedestrianism because it lacks the nuance, which is very important. And that nuance is the difference between expected inflation and unexpected inflation. This gets to the heart of markets as discounting mechanisms. They price in today what they believe about tomorrow. The fact of the matter is that commodities barely move when expected inflation surfaces. But when surprise inflation hits the tape, commodity prices run. Likewise, bonds and stocks don't like inflation, but they particularly don't like unexpected inflation.

Conventional thinking is baked into assumptions that millions of unsophisticated investors can be a dangerous thing, even when it's not wrong per se, but just incomplete. So then on this subject, why is gold not performing this year with so many people talking about inflation expectations on the rise? Well, first of all, let's just start with a fact, okay, for historical accuracy. Gold has not been a good inflation hedge for decades. Number two, we don't have rising inflation yet. We have people talking about it. It doesn't mean it's not going to come.

It just means right now we don't have it. Number three, if we did, it would be quite a stretch to call it unexpected inflation since people have been expecting it for too long to count. Let me reiterate a theme and then we'll close it up here. We believe value stocks are more attractive than growth stocks right now because we believe that long-term gains come from buying things at value prices that then grow through time. Buying great growth that was already priced in has not historically created sustainable long-term returns. Buying hot growth because you can time exactly when to sell, that could work. And buying hot growth as long as other

people keep doing the same and they're indiscriminately bidding your price up, that could work too. But I guess we don't do either of the last two ideas and I don't really recommend you try either. The Fed is normalizing monetary policy, and this has a great chance of making indiscriminate, passive, everyone wins, but high growth wins the most, an obsolete strategy. I'm going to skip the politics and money section here on the Dividend Cafe podcast. Other than this, a major issue not getting enough play in the financial media or in our living room discussions is the possibility of indexing capital gains for tax purposes to inflation. It would be, of course, a significant reduction of capital gain tax liability,

and it can actually be done legally by the Treasury Department without a vote of Congress. Effectively, this could reduce capital gain tax by as much as 25%. Obviously, the impact would vary around how long an asset's been held and so forth, so it leaves the impact of inflation, it would be higher the longer you've held an asset. By the way, both National Economic Council Director Larry Kudlow and Vice President Mike Pence support the move. No final decision has been made, but we're watching this potential catalyst closely. Okay, well, go to divinacafe.com to see the chart of the week about the inverted yield curve and past recessions. All things considered, a pretty boring week in the markets. That's the

way we like it. But hopefully you found this week's discussion on whether it be inflation, whether it be commodity and gold investing, whether it be the opportunity in the energy sector and education about upstream, midstream, downstream, or whether it just be why we believe in buying companies at reasonable prices and our thoughts around so-called value and so-called growth. I hope it's been informative, and we encourage you to listen every week. Set it up in your subscriptions on whatever your podcast player is and spread the word. Thanks for listening to Dividend Cafe. Thank you for listening to the Dividend Cafe, financial food for thought. The Bonsai Group is registered with Hightower Securities LLC, a member of FINRA and SIPC,

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