The Dividend Cafe - The Fed Waves the White Flag and Markets Throw a Party, Part 227

Episode Date: February 1, 2019

Topics discussed: Who Is Leading Who? What would Mr. Contrarian do? Catching a good return by the tail 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. I'm going to go through the main points at our weekly Dividend Cafe commentary. We're getting ready to close the month of January. And I'll tell you, I'm old enough to remember when we were at 21,700 on the Dow. And by old enough, I mean literally the day after Christmas. And now here we are looking to close the month of January right around the 25,000 mark. Volatility is a two-way street. And I'm always reminded that those who have a strong aversion to volatility really only have an aversion to half of it.

And I'm sure there's no surprise there. It's perfectly compatible with human nature. But as last month was a classic case of downside volatility, so January has been a classic case of upside volatility. So I'm going to jump in this week to all things Federal Reserve, although I'm not going to do a deep dive around the Fed because I want to elaborate on some of the fun stuff going on with the Fed, a little bit unpacking of what the Fed actually said this week and what changes they're making and where this whole central bank picture plays into the current environment. I'm going to do that in our Advice and Insights podcast.

So subscribe to Advice and Insights, listen to Advice and Insights for a deeper understanding of where the Federal Reserve plays this week. But as far as where we are right now, let's kind of unravel the whole kit and caboodle. The Fed did not raise interest rates this week. That was certainly baked in already. There was no expectation they were going to. But I think the news that facilitated the big four or five hundred point move higher in the Dow on Wednesday was the comments that the Fed had made after their non-hike. And if you listen to Chairman Powell

and go back to a couple of his fourth quarter speeches, and I mean literally, just like in December, you would think that these speeches have been separated by years of time, not weeks of time. That's how different the language, the tone, and the content has gotten in such a short period. such a short period um the fed removed language from their statement this week about maintaining their balance sheet reduction plans they instead talked about being and i'm quoting here prepared to adjust for normalization in light of economic and financial developments so it's code for we surrender um they don't see the need for any further hikes right now. This is, again, a very far cry from a few weeks back when they said we are a ways away from achieving the neutral level,

meaning they were a ways away from getting the rate up to where they wanted it to be. Now they're not seeing any difference. Now, again, I'm not being critical what they did or didn't do and what they're now doing and not doing. It is more the fact of just describing what is actually going on. I think there will be a flux around this policy issue, but not for a while. I think they're going to be in a pause mode for quite some time. Ultimately, more normalization coming out of the excessive accommodation post-financial crisis is still needed. But I think the Fed has realized that they've created more dependency on low rates, more dependency on easy credit than they thought. And unwinding that dependency is not going to happen without economic disruption. So the market likes this pause mode clearly.

Let me dive deeper into the Fed and market epicurean. Let's talk markets just at large, though, real quick. OK, the predictability of markets. Go back to Christmas Eve and the month that markets had just had throughout December. It had been a 15 percent trouncing in the month that markets had just had throughout December, it had been a 15% trouncing in the month. And then markets added another 600 point drop on a half market day of Christmas Eve. There was more pain, more uncertainty, more negative sentiment all around. And then let's say that from that context, markets's down 18% or something, Christmas Eve present of another 600 point drop, all that negativity.

And then I tell you the government's going to shut down for 35 days, stay shut down for 35 days on top of the negativity that was baked in at that point. Would you guess the market would be down 5% more, maybe 10% more? Reasonable. However, would you have predicted that the market from that day forward was going to be up 14% in a month? I would imagine you probably would not have, and neither would we have, and yet here we are. That's exactly what happened. Markets exist to surprise, embarrass, and confound people. Intelligence and data do not inherently, excuse me, let me say this in a better way. They provide an inerrant unpredictability that I don't think is ever going to change. They offer this uncertainty because that is what markets do, and that is where so much of the risk premium comes from.

The fact of the matter is that a truly intelligent understanding of markets is the humble recognition that in the short term, there is no predictable mechanism behind how markets work. Well, what would a contrarian, we pride ourselves in being very contrarian investors, what would a contrarian do given this lay of the land? It's sometimes difficult to juxtapose the wisdom of betting against the crowd with the wisdom of what appears to be common sense beliefs that have built up in investment assumptions. And two areas right now strike me as justifiably baked in and yet perhaps excessively baked in. Number one is that the yield curve is flat and staying flat and going flatter. And number two is that China faces its most difficult slowdown year in many, many years.

And as a contrarian, I ought to be investing in a steepening yield curve because clearly it is so baked in that that is not what would happen. Or at least I should be humbly aware of its possibility that the yield curve would in fact steepen this year, that there would be a larger spread between long-dated bonds, long-dated interest rates, and short-dated. And I think China may very well face all the pain that's been predicted for it, but the crowd is so overwhelmingly confident around that thesis, the distinct idea of a fiscal stimulus of some sort of reversal in the trade war issue, I would suspect that those could have a profoundly big impact on markets if the crowd were to have their expectations rocked one way or the other. I wouldn't take either of those

outcomes lightly, that the yield curve might steepen and that China may end up being better off this year than people are anticipating. We've talked a bit, switching gears to U.S. credit markets, we've talked a bit about the leverage that's built up in the corporate economy and why general access to credit is such a big issue this year and why we find the monetary policy regime so important, given where we are in the economic cycle. And I put two different charts up at Dividend Cafe this week. One is the small business owners that are saying credit is harder to get right now.

You see that number moving higher, but barely. It's still well below trend and has been so for a couple years now, but has modestly upticked. And so it doesn't tell a compelling story, but it tells a story worth watching. But then you look at the flows out of the leveraged loan bank market, which has become this prominent funding mechanism for corporate America. And it's very hard to argue that the Fed has been forced to put the brakes on their quantitative tightening because you see such significant flows out of the levered loan bank market, the levered bank loan market in the last uh month two months and when you see a drop like that it generally gives you an indication of how susceptible credit markets are um one thing i'm gonna off kind of just changing gears altogether but i really like this point i read a paper this week about uh tail risk and just so I don't catch you with these terms you don't care about or think are ridiculous.

We refer to tail risk in our business a lot. And it is a fancy term, but it just simply talks about low probability events that can do substantial damage. And they're called tail risk because of where they fall. And if you looked at a graphic bell curve the probability distribution it's way out on the tail it's a low probability event can do a lot of damage in in portfolio return and stocks that have greater exposure to alleged tail risks vastly outperform stocks that don't and and this isn't something that i'm saying as a surprise or as a profound discovery it's inherently true by the very essence of what risk premium is risk premium requires it to be

true because a higher return is expected where there is higher risk but by definition because tail risk so rarely manifests itself but that but alwaysers. It creates this risk premium in a given stock's return that doesn't always come to fruition. The risk part doesn't. Now, valuations reflect these risk realities. And we know that a stock's long-term return has a lot to do with the valuation paid for it. Therefore, the lower valuation, where there is a higher tail risk and betterness stock, adds to the return one can get from that stock over time. And if I've lost you, I apologize,

but it's important to understand. Saying that a stock has tail risk is not a negative. Saying that the stock market has tail risk is not a negative. It is part of the risk premium an investor is paying for. Well, how do we manage for tail risk? How do you hedge things? We're asking how you protect against things you cannot see and that you cannot predict.

And if you could, if you said, I'm worried about this happening. For example, company ABC is going to release earnings tomorrow. It's not tail risk that those earnings might be bad, that it might be disappointing. We know that going into earnings season, they may announce something besides people maybe with inside information, you know, something like that. But all things being equal, we go into an announcement not knowing if the earnings are going to be better than expected or worse than expected.

That's not a tail risk. That's a very high probability outcome of it either being good or it being bad. But tail risk implies things you cannot know across a whole economy, across a whole stock market, across a given company. And therefore, it's somewhat unhedgable. The way you defend against it is what we do via asset allocation. We have to construct an entire portfolio with appropriate levels of diversification and blending asset classes to produce the risk level one may be comfortable with. Well, let me ask you a question. Right now, where the market is after a really robust January recovery, is it time to breathe a sigh of relief? Is it time to breathe a sigh of relief?

Look, if you believe the possibility of near-term movements higher in stock prices represent a reason to breathe differently than you otherwise would, I don't really know what to say about that. The facts of the matter are these. U.S. economic growth is likely to prove steady this year, slower than last year perhaps, but growing nonetheless and at a steady pace. Inflation is clearly muted with both oil and housing in a different place than they were a year ago. You add to that a steady growth, non-inflationary environment, a Federal Reserve that is pausing, thereby not putting pressure on borrowing costs throughout the economy.

thereby not putting pressure on borrowing costs throughout the economy, you probably have a pretty good runway for stock market returns. Now, are there other factors to consider out there? Of course. But the big picture environment that was so concerning at different points in 2018, is inflation about to run higher? Is the Fed about to cut off access to credit? Is growth about to violently turn downwards? Well, at least for now, all those particular concerns seem to have changed quite a bit. The bigger question ought to be, I suppose, why the near-term pricing of equities would affect one's breathing at all. I don't breathe better when markets are good. For the same reason, I don't

breathe worse when markets are bad. Because we're managing for year-over-year dividend growth from our investments believing that that's a superior barometer for real and sustainable investment results devoid of the noise that so often plagues investor breathing on the political realm keep your your eye on the trade talks that are going on right now as I speak in the White House. With China, they're not up to the big powwow that will take place with President Trump and President Xi that is forthcoming. But senior negotiators on both sides are engaged in talks as we speak. We'll wait and see if anything leaks out there. I have a few comments, by the way, in DividendCafe.com if you're interested on the 2020 election.

And then our chart of the week gives you a look at what the S&P 500 has done for the last 10 years since the financial crisis. And it highlights the kind of moves down that have taken place along the way. The big one we had in Q4 of 18. A big one we had in early 16. The big one we had in Q4 of 18, a big one we had in early 16, a big one we had in mid-2015, there was one in mid-2011, and one in mid-2010. Five corrections that were more meaningful, and you can look at those up against the big picture chart

and understand why I hold perma-bears in such contempt, both morally and intellectually. All right. I'm going to leave it there this week on our Dividend Cafe podcast. Go now to Advice and Insights if you want to get a little more information on the Fed. If this scratched your itches, then good. Feel free to say so. Write us a nice review. Give us some stars. Subscribe in your feed for your podcast. And we appreciate all you do to support the podcast. And we hope you're finding the podcast supportive of what you're looking for as an investor. Reach out with any questions and offer us any comments, any time. Thank you for listening to The Dividend Cafe.

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