The Dividend Cafe - The New Normal is the Old - Sept. 16, 2016

Episode Date: September 16, 2016

The New Normal is the Old - Sept. 16, 2016 by The Bahnsen Group

Welcome to this week's Dividend Cafe podcast. We're titling this week's talk, The New Normal is the Old. We want to address a lot of this market volatility. Is anybody mad at me for last week suggesting the market needed a little caffeine? After 75 days of the lowest volatility and tightest trading range in decades, last Friday's market saw a nearly 400-point drop. Monday of this week, we then rallied 250 points up, but then we dropped 250 points on Tuesday before kind of going flat Wednesday

and then moving up a couple hundred points on Thursday. And then here now, as I talk on Friday, we're down about 80 points. So still actually up on the week a tad, but quite a bit of zigs and zags. So I guess be careful what you wish for, right? In all seriousness, the issue is not whether or not one wishes for volatility in the midst of a low volatility period. It's really whether or not one knows that such volatility is in the nature of things. Market volatility is always and forever inevitable, for it's the source of risk premium

that drives the long-term performance of markets. With that said, let's look at what is driving this bout of volatility and see what our approach to the period ahead will be. It will never be different that things will always be the same. Markets have functioned at certain levels of volatility since the beginning of time, and extended periods of above-average volatility always revert down to average levels. And inversely, extended periods of below-average volatility revert up as well. This is what we have seen this last week, mean reversion, whereby exceptionally low volatility played catch up to the norm. We expect volatility to be enhanced in the months to come

because the market is jittery around A, central bank policies, B, stock market valuations, and C, the Italian election referendum, and then D, almost everything else too. The proper investor response is not to dare believe they can trade in and out of it, but it is to use asset allocation driven by valuation fundamentals to drive a portfolio strategy and to not allow emotions to drive daily decision making. Of course, these three suggestions are permanent, not temporal. Take everything you know and turn it upside down. As we have been writing for many years, investors are free to enjoy the effects of central bank accommodation, and in fact,

it would not make sense to ask them to not enjoy cheap borrowing costs and the price impact such an environment has for risk assets. All we have asked is that investors not partake of this enjoyment without some awareness of what is going on, what uncertainties it creates, and what reckoning particularly awaits. One ramification of the present monetary environment that strikes us as both indisputable and problematic, though this year it's been very favorable to portfolio conditions, is the positive correlation between stocks and bonds we now have. Traditionally, safe asset classes like government bonds

have been a hedge against equity market volatility for a century. But in a world of negative bond yields, that is just not the case. We do not know when bond yields will normalize. And note, I'm talking about something that is different than what the Fed controls through short-term interest rates. And frankly, we do not know if they will normalize in the foreseeable future. What we do know is this, the conditions investors are fearful of right now regarding their equity holdings are not likely to help their bond prices any more than they are their stock prices. Policy paradigms that turn asset allocation rules on their head are not good.

Guessing who will be hurt the least by government policy as investment policy. It's well known that Dodd-Frank went to great lengths to limit the activities of the large financial firms, particularly with what they can and cannot do with their own balance sheets. The so-called Volcker Rule meant little or no proprietary trading and little or no merchant banking. Two areas that were left to analysis by the Fed were commodities trading, not on behalf of customer accounts, which is untouched, but on behalf of their own balance sheet. And then private equity investments, where limits were placed, but the highly profitable practice had not been outlawed. Last week, the Fed made its recommendations, which Congress will have to approve if they're to take effect. its recommendations, which Congress will have to approve if they're to take effect,

and it basically outlaws all commodities trading and all private equity investments at the large Wall Street firms on behalf of their own money. This would have a disproportionately larger impact on the peer investment banks and a somewhat diluted effect on those more commercial bank enterprises. The argument for this move is eliminating conflict and protecting balance sheet of those firms with implicit taxpayer support, but the argument against it is that global competitors are under no such restrictions. We see it as more of the same, a disintermediation process that will likely create winners and losers out of Washington, will likely create winners and losers out of Washington, but we have to invest for what is, not what ought to be.

When alphabet soup affects your pocketbook, bear with me here as I explain this, there's a lot of M&A talk for MLPs as PE money comes into the E&P space and the outlook for NGLs continues to improve. Well, that probably was a pretty frustrating sentence to hear, but let me walk you through what I mean, because this is a big deal in the MLP investment world, energy investors, etc. All I said is a lot of merger talk exists, M&A,

and the oil and gas pipeline companies, MLPs, that private equity money, PE, is attracted to in the whole energy sector, especially distressed parts of exploration and production, the EMP. Ultimately, we love the transportation infrastructure story because we see growing need, growing demand for natural gas liquids, the NGLs. Entities operating in the Permian Basin continue to be the most attractive domain. Drilling oil at $50 there is still very economic. But the ability to raise money has really been a great story in 2016 versus 2015 when capital markets had totally dried up.

So all my nauseating and confusing initials and acronyms notwithstanding, the substantive reality in the space is positive and we think opportunistic in your portfolio for years to come. I love it unless I hate it. When we look over the fixed income landscape right now, the bond market at large, we continue to feel more pressure and more anxiety than we do in the equity market. That's not because there's more potential for price volatility in bonds than stocks. That isn't true. But we know what volatility expect in equities. And we believe that price volatility is the cost of equity ownership and, more importantly, the cost of equity returns. And in our case, the cost of exceptional dividend income and the growth of that income that we're pursuing.

But with fixed income, we have to deal with, A, the fact that most investors do not know or appreciate that bonds can drop in price, too. appreciate that bonds can drop in price too. That B, bonds right now, especially regular, straight, long-dated government bonds, are way overpriced relative to historical valuations. And C, they are correlated with, not against, equities. We wrote, as we mentioned a moment ago. There's only two ways to make money in the bond market. That is with duration, the length of time that you have a guarantee of receiving interest rates, and then credit. Those are the two types of risks that one could take. The ability of the borrower to pay back and then the length of time that you receive a guaranteed interest rate. that you receive a guaranteed interest rate. We don't want to add to the latter risk, credit,

and the risk with the former, the duration of interest rate, is very severe because rates are so low. So what we feel is a really good risk-adjusted strategy within the bond world is floating rate bank loans, because we do not expect them to suffer losses at all if interest rates continue to go higher or begin to go higher, we should say. However, we do not expect them to suffer losses at all if interest rates continue to go higher or begin to go higher, we should say. However, we do know that if the risk proves to be a full-blown recession-like challenge, this sector will also become very volatile. The results in past periods of interest rate movements, we think back to the taper tantrum of 2013, were great, great returns in that environment for this type of bond strategy. So we like it as a big part of our bond exposure right now, mostly because we want to diversify

risk from rising rates. But should the economy really turn south, and I don't mean mildly, but more dramatically, we know we're inviting more volatility. So we remain nimble. I love stake. I do not love $10,000 steaks. What I believe will drive investment results in the next couple of years will be awareness of and respect for valuation. Right now, we have a world of people buying expensive bonds because, quote, they're safer than stocks, convincing themselves the valuation of the bonds don't matter. We have people paying 50 to 200 times earnings for certain growth stocks, convinced that high growth companies are attractive no matter what the price of entry. There are places in capital markets that have distorted valuations for understandable reasons,

primarily around the effort of central banks. My most earnest advice for clients and listeners, to central banks. My most earnest advice for clients and listeners, deep understanding of what central banks are doing and the impact to capital markets will be very important in the years to come and intelligent application of both that and the realities of valuation will profoundly matter when it comes to your return results in the years to come. Well, who sells a stake for a good price then right now? I'm making no comment on what certain overpriced asset classes will do in the next month, quarter, or even year. Valuation oddities can last longer than people believe, and they can do so

because of perfectly rational reasons. Though we think the most prevalent reason right now for valuation oddities is investor response to central bank-created distortions. Are large parts of real estate, not all, overvalued by historical measurements? Absolutely. Are government bonds, especially long-dated ones, overpriced as much as any asset class we follow? Where is the relative value then, at least in terms of historical levels of valuation compared to current prices? What is not expensive? Many energy investments continue to offer value. Emerging market stocks, more so than bonds, are relatively attractive. This is in comparison to their own past valuations. attractive. This is in comparison to their own past valuations. Much of the financial sector,

insurance companies, banks trade below standard levels. Our bias will be towards value over growth forever, but especially so for the next few years. We have a chart at dividendcafe.com this week showing historical reaction to really big downside days like what happened last Friday that we think you might find very interesting if you want to go to the website DividendCafe.com. I'll close with our quote of the week from Joan Robinson. We learn economics not to understand economics, but so as to not be fooled by economists. Well, what a week, what a year it's been overall. I'll tell you, all eyes are on the central bank next week. Largely what they may say about the future more than what they actually do next week. Our eyes are on that, but also on the bond yields that are out of the Fed's control. The yield curve is definitely

steepening and that's what they want, but we shall see how these things play out. Enjoy your weekends with the knowledge that your portfolio is in good hands and may USC please somehow beat Stanford. Enjoy your weekend. We'll come back to you next week at the Dividend Cafe podcast.