The Dividend Cafe - The Standout Opportunity for Those Looking

Episode Date: April 6, 2017

The Standout Opportunity for Those Looking by The Bahnsen Group

Welcome to the Dividend Cafe podcast. We also love for you to check out DividendCafe.com where you have all this information and more in written form each and every Friday in your inbox. And we include a lot of charts and other types of fun things in that version of Dividend Cafe. With that said, let's kind of get into it. We have come into the second quarter of 2017. It's been a reasonably sleepy kind of week. There was a big move up on Wednesday and we gave a lot of that back. But, you know, we kind of have just sort of bounced around and so forth. political impact on the markets as the week commenced. Most market participants are basically waiting on their hands for earnings season, which will kick off late next week. A slew of the financial companies will release earnings late in the week. And this is kind of a time to debrief on the first quarter of 2017, evaluate a number of crucial things that inform us on how we want to be positioned as investors right now so let's get into it

q1 is in the history books the Dow was down about 0.7 percent in March and S&P the S&P 500 was essentially flat but both indexes climbed Q1 about 5%, 4.5% plus change for the Dow and about 5.5% for the S&P. The amazing winner for Q1 was emerging markets, which were up 12.5% on an MSCI index basis. MLPs, master limited partnerships, primarily in the oil and gas pipeline space, grew 3.9% total return. That means with the income included from the Illyrian MLP index. And that's despite oil dropping 5.6% and natural gas prices dropping 14.3%. The top performing sectors in the stock market were technology up 12.5%, healthcare up 8.5%, telecom and energy were the only negative return sectors, and within fixed income, longer dated municipal bonds enjoyed a nice comeback from the Q4

debacle of late last year. High-yield bonds continued to do well, maybe too well. And regular government, agency, mortgage-type bonds all generated positive returns, somewhere between 50 and 80 basis points. It was a good quarter for investors no matter how you slice it. Looking to feel threatened. It has not been hard for people to find various reasons to doubt the sustainability of this stock market rally. The most popular reason to believe markets could reverse in future weeks has been around the Trump economic agenda getting derailed.

Our belief is that there will in fact be elevated volatility around the political journey, but not derailment. Another fear has just been general valuation levels, and we discussed those in a moment. You know, the Fed, their approach to monetary policy right now deserves consideration. Everyone knows they're slightly raising rates, but will them reducing the size of their balance sheet derail the rally? We would argue, no, probably not. In fact, it could serve to diminish inflation fears, which increases overall market confidence. Excessive or sudden or unexpected monetary tightening could always throw water on things, but that doesn't strike us as very likely. The biggest threat would come from a failure of the hyped up expectations around U.S. profit

growth to materialize. As earnings go, so goes the market. Context is everything. We talk a lot about an S&P 500 trading at 18 times forward earnings right now, which it surely is, and how that reflects a small premium to the roughly 16 times multiple the market has averaged for a few decades. Our point is always to demonstrate that A, the market is not dirt cheap, but B, the market is not frothy expensive either. Generally, earnings multiples do overshoot a lot more than that before a market correction. But we are value-oriented investors, and our biggest point has been be selective, buy discerningly, for the broad index passive approach right now is expensive. One more comment on market valuations is in order.

Throughout the 25-year period, that average is 16 times multiple in the S&P 500. We also had an average yield in the 10-year Treasury bond of 4.5%. It's presently less than 2.4%. In other words, the comparative value from the alternative to stocks is much more expensive, meaning the multiple of the S&P should be more expensive too. The less the yield is in the safe rate, the expected return of government bonds, the more investors will be willing to pay for a certain stream of earnings from stocks. So while the P-E ratio matters and is more expensive than we like,

when compared to and adjusted for bond yields, it's rather logical and frankly expected. Clarity and Context A better way to say what I said before is this. Valuation is not a timing tool. This is not to say that valuation doesn't matter. It matters a great deal. But it is to say that valuations are utterly

worthless and dictating the timing of entrances and exits. As pointed out above, valuations generally have to be understood on a relative basis as well as an absolute one. And valuations also do not transcend what is actually a permanent reality, that timing doesn't work. We like the idea of buying things that are cheap and selling things that are overpriced, specific actual investments, but to believe that any tool exists that provides you a ability, whether it's valuation of a broad, large market or anything else, that provides you the ability to time the market is utterly dangerous. to time the market is utterly dangerous. The standout opportunity from Q1. When I look at the quarter that just was, one particular thing stands out to me the most. MLPs, the index which

was up just 3.9% with dividends in Q1. On one hand, that's a pretty good return, we suppose. Many investors, though, continue to mistakenly believe that MOPs are connected to the prices of oil and gas. Prices which were actually down in Q1, even though MOPs were positive. But to see the non-correlation manifested is helpful. Let's look at the lay of the land to better examine our own thesis. First of all, sentiment for oil and gas pipelines has been atrocious for well over two years. We see this as a big picture positive when assessing future opportunities. Who wants to buy something that everyone has already priced up to lofty expectations?

The production volumes of U.S. oil and gas are growing higher. That's undisputable. The yields offered by these investments, their average levels are nearly triple that of bond yields. In other words, they're widespread, which equals large attractive income opportunity with growth of income to boot. Even though volumes trump prices, one still likes to see a stable commodity price backdrop. Oil seems reasonably comfortable around the $50 level. Natural gas above $3, providing a very different context than where we were 12 to 18 months ago. And last but definitely not least, the political environment is clearly highly favorable to this sector

from a regulatory or should we say deregulatory standpoint. This hardly seems priced in. We know burned retail investors of 2015 are going to be slow to come back to the space but for all the fundamental reasons listed here we believe the oil and gas pipeline space is the standout opportunity coming out of Q1. I'll give you higher taxes here for lower taxes there. One of the big risks in the House Republicans not coming to an agreement with the White House on tax reform, and the Senate Republicans matter here a great deal as well, is that the planned tax reform package the Trump administration gets behind may look a lot different

if the White House decides a bipartisan approach is more politically necessary. Concessions to a higher capital gain tax for high earners in order to get a less-than-desired reduction in corporate tax rates would likely hurt markets on both ends, even as the Trump administration could chalk it up as an accomplishment. Our reading of the tax leaves does indicate the border adjustment tax is dead, but what will it take to get Republican consensus around a tax plan that meets the Trump administration's agenda and is favorable to markets? Well, that's not totally clear just yet. I'll close you with the quote of the week,

to give money away is an easy matter and in any man's power, but to decide to whom to give it, how large and when, for what purpose and how, is neither in every man's power nor an easy matter. Hence it is that such excellence is rare, praiseworthy, and noble. Aristotle. Thank you so much for listening to this week's Dividend Cafe podcast. We look forward to coming back at you next week with lots of more information. In the meantime, reach out to the Bonson Group anytime, any questions, and check out DividendCafe.com. Thank you for listening.