The Dividend Cafe - The Halfway Point of 2021

Episode Date: July 2, 2021

I have always had a sort of unfair pet peeve with people talking about time moving either too fast or too slow. I think what I hate is the thoughtlessness of it – the sort of expected cliche when someone says, “wow, this year has flown by.” For one thing, it can’t possibly feel that way for everybody, yet it seems like everybody says it. Plus, it often times is just patently false – what people say they feel is the opposite of how I feel, and therefore I assume they must be wrong. I know, I know, but I already said it was unfair. The first half of 2021 did not “zoom by” and it also has not “dragged on” – for me. There are moments I can look back on and say “that feels like it was years ago” and there are other moments (perhaps more of these) that I do feel came and went quickly. At the end of the day, the holidays and the turn of the year were about six months ago. That much I know is true. As I do every year, I wrote a lengthy white paper between Christmas and the New Year to recap last year and to lay out our themes and perspectives for this year ahead. I prefer to wait for the next six months to do a deeper dive there, but I will check in this week on some of those perspectives. But primarily what I want to do in this week’s Dividend Cafe is give you a look at what has transpired so far this calendar year, and why. Accurately knowing what happened in financial markets is useful – and not to be taken for granted (remember, “what you know that just ain’t so” can be dangerous stuff). But I really want to explain today why things have played out how they have, and from there offer up a viewpoint on the future. Jump on into the Dividend Cafe … 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, hello and welcome to a, I think, special Dividend Cafe. We're at the midway point of 2021. And so I am here to bring you listeners of the podcast and viewers of the video a little recap of where we are halfway through 2021 and what we're kind of looking to into the second half of the year. As we delve into the third quarter, it is kind of surreal to think about where we are because you're looking and analyzing and thinking

about markets while at the same time doing that through the whole context of what's been going on with COVID, what's been going on with our national politics, the election we had seven, eight months ago. You have a lot of things that all kind of overlap with one another. And for one thing, it distorts our view of time. And I talk about that a little bit in Dividend Cafe today, that you get this sort of mixed feeling of, oh, it seems like it's been forever, or it seems like it's just been yesterday. I think that's a lot of the reason why people have these kind of cliche responses

about time going by is because it's a mixed bag. I mean, there's a sense in which it does seem like things have been going on longer than they have been and another sense which has gone so quickly. But just isolating to the calendar year 2021, the way I think about these things is that the calendar year is useful as a kind of differentiator in markets from one year to the next. Technically, what should have changed in markets from the second week of January versus the third week of December? Obviously, nothing. It's totally irrelevant except for you need kind of points of segmentation. and calendars help provide some of that divisibility in the way we look at markets. So I think that's useful. But for me, I have sort of a

structure to the way I live my life and the way that my calendar years go. And I have for a long, long time taken the week after Christmas going into New Year's to write a white paper that will summarize everything from the year before and kind of offer forward-looking perspectives in the year ahead. Because for one thing, a lot of the things I was talking about as a 2021 forecast were at the end of June 21 now going into July. And the stories already kind of played themselves out. Some are still playing out. I'll talk about that in a moment. But my point is that if someone had told me when I was writing that white paper that six months would go by and I would feel the way I feel and the things would have happened the way they've happened. And the media would cover stuff the way they've covered it. And then the narratives that would take hold in markets would have been what they've been.

Some of them would have surprised me. Some would not. But I do believe that there is far more rationality and expectation to what has taken place in markets than others may feel. There's other things that I think are still a little cuckoo. And we're going to talk about some of that. But let's just kind of get down to the brass tacks of it all. The fact of matter is that just on a basic market summary level, the S&P is up roughly 15% halfway through the year. The Dow is a little less than that at about 14%. The NASDAQ is up about 12.5%. And yet, like half of that was in the last few weeks. So the NASDAQ had been the big laggard and it actually at one point retested. It's low

for the going into slightly negative territory for the calendar year, come back quite strong. Small cap index, even though all of this really took place in the first quarter of the year, the Russell 2000 is up over 17% of the year. So those are the four major and most broad market indices, the Dow, S&P, NASDAQ, and Russell 2000, all of which basically being up somewhere between 12% and 17% in six months. I put a chart at Dividend Cafe to show you the S&P going back for 12 months. So from the end of June of last year through now, it just looks like this straight diagonal line up. Now, the fact of the matter is there were a couple of kind of bumpy moments on the way.

And in the way the whole chart is played out as the S&P has gone from 3,100 to 4,300, it doesn't feel like any of that choppiness mattered or even ever happened. But at the moment it was happening, it did. And this is a very common thing in markets, by the way. But I do want to cover a couple other pieces along the way, just to give you the backdrop of what's happening in markets. And then I want to talk about why these things have gone the way they've gone and what we're looking to in the latter portion of the year. Within these broad market indices that have done pretty well, it's been far more Darwinian, far more dispersed than it would indicate. You sometimes have periods

where markets are 10% and pretty much everything in the market is up between 7% and 13% or something like that. That would be a hyper narrow dispersion of results. Well, the top performing sector in markets this year is energy, and it's up 45%. And energy was by far the worst performing sector last year. Now, this dispersion is pretty dramatic, but utilities are the worst performing sector. And even with the dramatic dispersion, they're still positive. So 11 out of 11 sectors in the equity market have a positive return in the calendar year, but utilities are up about 2.5% year to date. Nothing is really all that close to energy at 45, but in second place is financials, which are up 26%. So those were two of the laggards last year, and then the two leaders this year.

Pretty interesting. Now, the bond market I'm going to talk about more, especially as we look into the second half of the year around the yield curve and around credit conditions and what it says about pricing risk right now in just the overall financial universe. in just the overall financial universe. But I think that the 10-year bond deal going up 75 basis points and it being down 30 basis points from its high is the big story. It's led to a lot of conversation, a lot of hand-wringing, a lot of back and forth on things that means,

things that turned out not to have meant, whatever. But whether or not one is directly trying to invest in the fixed income space and play bond yields, or just what it indicates about overall financial assets right now, and economic growth and so forth, the 10-year has been something to behold, primarily for how it is so uncooperatively moved relative to the narratives of the day. International market indices are all mostly higher. It's actually Sweden's, by the way, in Europe that is the highest performer. But the developed EFI index is up at 11%.

So it's up nicely, but just still pretty significant underperformance relative to US market indices. And then the emerging markets is up 7% as a broad index. A lot of that's due to a weakness in some of the Chinese internet stocks that permeate that index. So what does this mean? When you talk about the S&P being up 15%, I think that ends up placing it at the 12th to 13th best first half of the year of all time. So that's something. But 13th best of all time is not that big of a deal. And the fact that we've had 34 new closing highs this year, I think is yet another mathematical reaffirmation of the silliness of looking at closing highs as some kind of a relevant data point. whether they're more actively invested, whether they're more focused on value or quality or dividend growth, which are the kind of the things that matter to us, whether or not the sector

allocations are more particular, or they just simply mirror S&P sector weightings. The fact of the matter is that there's still a pretty fair question as to why market indices have done so well this year after having done so well last year and through the challenges of the moment. We are told that there's this possibility of big tax increases coming. We're told there's this probability not only of inflation coming, but inflation already being here. We know markets have already had a big move up. So there's all these headwinds and markets have kind of done what they've done. And of course, that could all just kind of be reversed.

It could all move the other way. But it does beg the question as to why markets have done what they've done. And here is the answer I will give you. I believe that there are three major issues that people have to understand. And just speaking to broad performance of risk assets in 2021 thus far. And number one, and these are in order, by the way, I think number two and number three are very significant. Number one and number two affect number three a lot. But I'm going to start with number one, which is the vaccine. From start to finish, you, first of all, already last year had a better than worried market environment because COVID was not as fatal as people originally feared it would be.

And because the most vulnerable part of the population proved to be far more identifiable than people initially feared. proved to be far more identifiable than people initially feared. So you already had kind of a backdrop of the COVID scenario not being what had priced in as a left tail risk in the spring of 2020. But nevertheless, you had a highly infectious disease that was less fatal than feared, and more identifiable in terms of vulnerabilities. But then there was the thought process that a vaccine would take X number of time and would have X number of challenges in getting it rolled out and distributed. The fact of the matter is that the vaccine came far quicker and it wasn't a singular vaccine. It was plural and it came with much better efficacy than had been expected. So you got it. You got it several times over with the Pfizer, Moderna, Johnson & Johnson, et cetera, and you got a much

higher efficacy of what we did get. Then you had what was on a relative basis an outstanding rollout, but on an absolute basis, a pretty darn good rollout too. People could point to little pockets of challenges here and there, but more or less, we were able to get this by March and into April with a high degree of penetration of the vaccines out of society. They also proved resilient against these different variants and other things that would pop up. So this is the number one story, okay? There was an economic reactivation that exceeded expectation. Markets do well when things exceed expectations to the upside. But then number two is this is happening with a backdrop of highly accommodated monetary policy. So you're not only getting all

the reaccelerated earnings and reaccelerated economic activity markets have to price in, you're getting it with something that is allowing a boost to the valuation of the very benign economic backdrop because of QE, quantitative easing, and because of ZERP, the zero interest rate policy. Those things put, obviously, highly aggressive downward pressure on the risk-free rate, which pushed a lot of upward pressure on market multiples. So you get a higher valuation of a growing and positive economic circumstance. Then number three was profits. And corporate profits were aided by vaccine pushing reacceleration and by lower debt service costs because of a benign monetary policy

environment. But be that as it may, whether it was from number one, number two, and just other circumstances, we started the year, I put a chart of this in Dividend Cafe, expecting 23% year over year profit growth, which would have been huge. We're now tracking that we're going to end up at 37% year-over-year profit growth. So obviously, profits had troughed to some degree out of the COVID moment, the lockdowns. We expected an awful lot of profit recovery. We're getting all of that and then some. So it's a major story for 2021 stock prices. It's also, in my opinion, a story for 2022 stock prices because we expected profit growth next year to be about 16%. Right now, it's going to end up being probably closer

to 11% or 12%. All these things fluctuate as circumstances change. But why are profit growth expectations for next year come down? Because the profits that we experience next year will grow off of a higher number because of 2021's profit outperformance. So you get a kind of multiple effect in that into the future. I think that's important to understand. One of the things I want to kind of focus on is what this COVID recovery, because it is unique. It is very, there's not a direct precedent to what this economic recovery looks like. You can compare it to financial crisis. You can compare it to the 82 recession.

There's all kinds of things that have happened, bad in markets over the years, compared to dot com. But this was specific to a global health pandemic. And there was a lot of fiscal and monetary response, both domestically and globally. There was a lot of fiscal and monetary response, both domestically and globally. But it's different than in a kind of organic or homegrown recession that we may have had with like a credit crisis or with an asset bubble bursting like dot com. So you always have to look to these things where there are historical parallels with an understanding of where they're not historical parallels. But I think that we're now looking at a recovery before it kind of consolidating and slowing down in the market, not the economy, the stock market, that has gone a little higher

at this point in time and a little longer than some of the past recoveries. And I have a chart of these overlapping things that you can look at at dividendcafe.com. So does that add to the kind of risk level? Does it reaffirm the idea that we could be due for a correction? My view on this is very simple. If you need that anecdotally to reaffirm the fact that a correction could be coming, then by all means, you know, take note of it. It's just that you shouldn't need that to tell you because that reality is there no matter what. My view is that there are normal corrections that we ought to expect and we haven't really even had one of those. So to me, just simply being generically aware, generically defensive, generically conscious of our own appetite for volatility is a wise thing for us to do now and at any other time. But I think that when you look at a couple of the themes that have been heavily discussed

throughout 2021, the few I want to focus on are, first of all, this growth to value type story. And I do think, interestingly enough, that 2021 was a story of value over growth so far, yet the second quarter, and especially June, was a story of growth over value. So that really just speaks to how much of a head start this calendar year value had over growth. But in reality, a lot of the growth stuff is hung in there just fine, or at least has rebounded quite nicely here in the last several weeks. Do I believe that there are excessive and frothy valuations in the NASDAQ and technology and big tech. I do. I just think it's a kind of unhelpful thing to say. I don't know when some of these things revert to the mean. I do know

that generally speaking, they always do revert to the mean. It's a law of nature. But along the way, a lot of things can happen and they can take longer than a lot of people expect. A lot of things can happen and they can take longer than a lot of people expect. As a general secular theme, my expectation is for an extended period of value outperforming growth as far as those general styles and broad generic descriptions are concerned. And I would add to that that the risk paradigm makes that even more true. In other words, regardless of what actually happens with performance, the skew of where that risk-reward trade-off is heavily favors value over growth for all the valuation reasons and economic circumstances that we've described.

The big major financial story that God knows I spoke about ad nauseum here at Dividend Cafe, and it was covered extensively throughout financial media and with a lot of market commentary, was about inflation. I want to point out back in late March when bond yields peaked on the year, when the inflation story was now really becoming the headline story du jour, that since then, utilities are flat. Consumer staples are basically flat. They're up like 2%. The growth has actually outperformed value since then. Bitcoin is down almost 50%. It's down over 40%. And they talk about Bitcoin, albeit, in my opinion, erroneously, as some sort of an inflation hedge instrument. So there is a lot

of inconvenient actuality out there in the face of various narratives. The inflation story is very complicated for all the reasons we've talked about. We are living through a period of price levels, some of which are very high in their price movement versus very low price levels of a year ago, this so-called base effect. And so that skews the conversation. It certainly complicates it. The supply disruptions, particularly in the semiconductor space, have had a profound impact on supply demand and ability to get product to different places,

ergo pushing prices higher in a lot of cases. We know about the $5 trillion of additional government spending that has happened as a result of three COVID bills. And then, of course, the story of bond yields, which is, to me, one of the great arguments of the inflation thesis being inaccurate, has been a really important story to watch along with all the other dialogue that has taken place about the supply chain or about lumber prices or whatever the case may be. My own view is that you have an economy that people pretty much consensus view, is going to grow somewhere between 6% and 8%. Real GDP, our economic advisor here at the Bonds Group thinks it's going to be even higher than that.

And you have a 10-year bond yield at 1.45%. Now, no one believes that 6% to 8% of economic growth is sustainable. It's all recovery-driven growth. But my point is that you do not have a bond yield indicating anything other than extremely low growth and low inflation in the economy. Something is wrong and something is right. And my view is that the bond market is right and the consensus view is wrong. But I do not believe that all arguments for inflation concerns are thoughtless. I think it is reasonably thoughtless, or at least not fully informed, to just simply point to lumber prices moving way higher or used car prices and saying, see, look, we told you inflation.

However, I think a more thoughtful argument about inflation would be, OK, there's a lot of transitory effects. There's a lot of base effect. There's a lot of supply disruption, idiosyncratic circumstances, and that is probably distorting the present inflation picture. However, we think a lot of these things are going to end up getting anchored and being sticky, therefore proving inflationary into the future. I don't agree with the view, but I consider it a very thoughtful and prima facie plausible perspective. But it still is rooted in an economic view that believes government debt is inherently inflationary. When I not only do not believe government debt is inflationary, I believe it

to be the opposite. I believe it to be disinflationary. And this is something I've talked about so much throughout the year. The budget deficits we have right now being about 19% of GDP. You got to understand during World War II, it was 20% of GDP. So we're right at like World War Two levels of deficit to GDP ratio. Yet immediately after World War Two, we got that number down to 7%. And the next year down to 4%. The deficit to GDP collapsed post war spending. And that's just not going to happen this time around. The deficit to GDP numbers are going to stay highly elevated. And it is my opinion, when you look back at the history of debt bubbles in our country, that it has created more disinflationary factors than anything else. And all of the things I've talked about throughout the year have led me to try to form a macro

formulation to expect low growth, slow growth, and favor quality for that reason, believing that we have a problem of national savings in our country as a result of excessive government debt. That problem of national savings means there's less money for investment, and the less money for investment means you get less growth and productivity over time. This is not the stuff inflationary booms are made out of. All that up against a time in which I think the Fed's monetary policy options are very asymmetrical. They can absolutely slow down the economy by tightening monetary policy, but they cannot prime the economy at this point with more

loose monetary policy. They've already gotten to the zero bound, so they've lost the weapon of offense, and then they still have the other side that's an asymmetrical monetary policy that I think has to be understood. So I'll stay off the inflation, deflation obsession beyond that, but it plays a lot into what has taken place this year, what a lot of people are talking about when they analyze the current market circumstances and gives you a reaffirmation of what our view going forward is. What do I believe is going to be the theme for the second half of the year. I don't expect another 15% return in markets, but how can we get more positive returns and where will those positive returns come from? I think so much that will depend on the yield curve. This gets to be a little bit more complicated. The yield curve had widened out quite a bit. It was up around 160 basis point spread,

1.6% difference between a two-year and a 10-year. And that number right now is down about 125 or 130 basis points. And I think if the yield curve flattens further, that probably is negative for all risk assets. If it widens, then it is probably good for risk assets in general, but particularly good for value financials, maybe not as good for technology and high PE stocks. However, in the context of the yield curve moving, I would also add just overall credit circumstances that you're looking at extremely tight spreads with both investment grade corporate bonds and high yield corporate bonds. And that is not so much important for a lot of people's investments directly unless they, of course, own those types of bonds. It is important for our purposes or to what it indicates about risk level throughout the

whole economy and risk level throughout financial markets. And when I'm looking at investment grade corporates at about 80 basis point spread, very, very tight, almost as tight as we've ever seen. 300 basis points in high yield. That is not at all the tightest we've ever seen, but it's very small. And it just indicates a lot of stretch for yield. People having to push out the risk curve to reach for return. That can go on for a long period of time, but it does generally not

end well. And it generally creates an elevated level of risk in the financial markets and a kind of distortion of risk and reward trade-offs. So as far as the remainder of the year, I'm going to leave you with three concluding thoughts. There are pockets of excess and speculation that I don't happen to believe the bonds and groups invested in, but I think that they are permeating across a lot of investment universe. Whether it's the crypto and the meme stocks and the really kind of speculative tech space, there is just simply different things right now that are very popular that I think speak to a greater silliness and euphoria than fundamentals and logic. I have no interest in saying that that's going to end in September or going to end by December.

I have no call on that whatsoever. I just simply know that whether it was the Japan bubble in 89, the dot-com bubble that I lived through as a professional investor, the financial crisis that was a defining moment in my whole career, these are bubbles in history that I've studied extensively that the bubbles had formed way before they ended up actually bursting. So the fact that a bubble can form and stay for a while is not new and is not in any way to be taken as a positive sign. When a bubble sticks around a bit, it does not mean it isn't a bubble. I believe people are wise to peel back from some of those things that may be more driven by euphoria and popularity and the faddishness of the moment and less

defensible from a mathematical, economic, logical, or reasonable standpoint. Number two, I do believe the risk-reward skew favors value over growth. I think that what we saw in Q1 is more likely to be the theme later into the end part of the year, but I don't think it'll happen in the same way. You had deeply undervalued areas in energy and financials that were huge leaders in the early part of the year. And I think right now you're more likely to see value outperform, but with consumer staples. Perhaps utilities get back in the mix as well, consumer staples. Perhaps utilities get back in the mix as well, but I think that the sector weightings or, excuse me, sector leadership will change relative to what it was earlier in the year, but that macro theme of value outperforming growth is very likely to continue. And then number

three is I just think the political risk was so perversely misunderstood and overstated, was so perversely misunderstood and overstated, both going into the election and then throughout all of Q1, Q2, all of the hand-wringing, they're going to do this, they're going to do that. And I think markets just continue to shrug it off, even as the media and a lot of investors and a lot of advisor community continue to believe, oh my gosh, they're tripling our capital gain taxes tomorrow. What do we do? Well, I think all of that was tremendously overstated. And now I believe it has the possibility of becoming understated as we get more clarity as to where these things are going. And I don't mean what

President Biden says or what NBC says or what Fox says. I mean, what can get done legislatively that can actually become law, that then we will have a chance for markets to be able to fully price those realities in. And my belief, as I've said countless times, was that the worst case scenarios and all of those things were highly unlikely to happen. But the best case scenarios are probably not going to happen either. Markets have probably priced in something a little bit But the best case scenarios are probably not going to happen either. Markets have probably priced in something a little bit worse than best case scenario. So on the margin, political things by the end of the year will become more pertinent than they are right now. In our chart of the week, by the way, at Dividend Cafe, I go quite extensively into housing prices.

I put a chart about this just hockey stick leg up in the percentage of growth in housing prices, why I see it as mostly a negative thing, but having sprinkles of positive in it. The fact that 87% of homeowners right now have 80% or less loan to value, meaning 20 percent or more equity is one of the great blessings of our time as it pertains to housing prices relative to the last time we saw this kind of euphoric move higher. Equity is the great protector here. It was 26 percent of homeowners in 2009 that had over 100% loan to value, meaning negative equity. So that becomes the point at which all hell breaks loose. I don't think we can go back there because we simply have greater protective equity and we have better underwriting into the loan profile of America's debt on its housing supply. But we are under built in housing, largely as a hangover from how overbuilt we were pre-crisis.

We had a long period of time where there was inadequate household formation. Now, demographically, we've shifted to where there's more household formation. We have an inadequate supply. You then combine the octane of very low interest rates on this, and you're just getting stupid prices in housing again. Does that lead to systemic risk? I don't think so. However, it does if and when the speculators come back in in droves, and they haven't yet. I think that they will, but they haven't yet. So supply needs to come up. Demand is going to continue to be quite high, I believe, for some time. And then the interest

rate level is really needing to normalize in order to create a bubble-like condition that draws in speculators and then gives us a negative feedback loop none of us want to think about. So I've covered a lot of ground there, but I hope you've gotten a kind of picture of what's taking place so far this year, good, bad, and ugly, where some of the narratives have been off or where we offer a kind of contrarian view on some of those narratives and what my perspective is going in the second half of the year. I do feel awareness about elevated price levels, about some euphoria. I'm continually focused on avoiding those pockets that I consider to be rank excesses in financial markets.

And we're ready to face the second half of the year with the principles that we bring to every year at the Bonson Group, which I think you know very well if you're a long-time listener and reader of the Dividend Cafe. I'm going to bid you adieu now and wish you a very happy Independence Day. Enjoy your 4th of July weekend. Please celebrate, as me and my family will, the birth of this great nation, the birth of the American experiment, and everything it represents as you pursue life, liberty, and your pursuit of happiness. Thanks for listening to and watching the Dividend Cafe. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC.

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