The Dividend Cafe - The Surprises of 2018

Episode Date: March 22, 2018

This week, David L. Bahnsen covers the years in markets and reveals his views on whether or not investors should expect more surprises in 2018. Links mentioned in this episode: www.DividendCafe.com www.TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's edition of Dividend Cafe podcast. This is David Bonson, Managing Partner, Chief Investment Officer, and if I remember correctly, I founded this little group called the Bonson Group. and if I remember correctly, I founded this little group called the Bonson Group. And we are delighted to come to you with a whole host of market discussion items this week. We encourage you, as always, to go to DividendCafe.com if you want to see charts and read through the whole thing. But we're going to try verbally to give you all the same material here in this podcast. And we would also encourage you, for those who really enjoy podcasting and with that

enjoy hearing us podcast, meaning share whatever investment insights we have, to check out our Advice and Insights podcast property. It's available at all the normal spots you would expect. And there we try to do weekly content, a little longer form, deeper dive. Last week we got into emerging markets discussion with our emerging markets portfolio manager. This week our fellow partner here at the Bonson Group, Kimberly Davis, shared a lot of her wisdom about the fiduciary standard and also about the concept of education and preparation for female investors and what we're calling our fiscal feminist program that Kimberly is launching. just fantastic stuff there, Advice and Insights podcast.

But as far as Dividend Cafe, the first quarter of 2018 will come to an end next week. A great effort will be exerted by us and others to analyze what all took place in Q1, what it means, how we should feel about the state of the markets, both in the present and the future. Undoubtedly, investors will feel there were high points and low points in the quarter. Certainly, some will promote the idea that there were surprises. Indeed, we talk about the surprises of 2018 ourselves. We're going to do so even more in a few minutes. But should the word surprise ever be used when discussing the world of investing? Is anything less a surprise than the reality of surprises? Perhaps that should be the lesson of Q1, that when there is no volatility or high volatility, or something that zigs when you think it will zag, or relationship between two assets that behaves even more abnormally, picture

the air quotes I'm using right now, none of it is actually a surprise. That is certainly the major lesson I've learned in a career of managing investor assets, the lesson of not being surprised. Let's unpack all of this and more in this week's trip into the Dividend Cafe. The Ides of March. Since the initial market panic attack of early February, we saw markets stabilize, then rally up, only to see another rally down in late February upon the announcement of White House tariff intentions. Coming into March, we rallied in the early part of the month after the market

digested that the tariffs were more bark than bite, and as greater economic news was announced. But now in the last week or two, we've given up those March gains and are sitting back near where we started the month. What explains the downtick of this week? Oil prices, after all, are advancing. Economic news has been expectedly solid. And we are not in earnings season, so therefore there's been no earnings disappointments to speak of. Essentially, we have fragile markets right now in terms of day-to-day volatility. There's not enough clarity that new Trumpian trade policy will be the protectionist disaster he has threatened, but nor is there clarity that it will not be. Markets recognize there's a lot of negotiating and posturing going on, but also recognize that

some of what is being jockeyed about is truly concerning. Add to that level of fragility, tremendous vulnerability this week in some big tech names that have been leading the market, and ongoing drama around the White House, Mueller, special counsel investigation. There's just enough noise to create volatility. And of course, all this must be understood in the context of a market losing some of its put, some of its backstop, if you will, from the Federal Reserve. Not all of it, but just an incremental slow drip of healthy normalization in monetary policy. But the fundamental backdrop is this. There is an inflation versus deflation debate playing out that does matter, and there is a strong earnings environment in a strong economy that does matter. Does this leave us bullish or bearish?

It leaves us cautious, but for totally different reasons than what is driving market volatility. Surprises worth noting in 2018. As our key forecast for 2018 centered around a melt-up in the market, January, check, increased volatility over 2017, February and March, check, conversation increase around inflation, check, and a heightened scrutiny sociopolitically in the new tech sector. Check, check, check. It is tempting to think that we have all this pegged right now. However, there are some key surprises taking place in the capital markets, and they represent the major challenges we're debating and discerning. Number one, well, growth has actually outperformed value year-to-date, despite higher market volatility, a weaker U.S. dollar, and higher interest rates, all things that should bode well for value over growth on a relative basis.

Oil prices are up quite a bit. The Trump administration has proved every bit as friendly to the energy sector as we had hoped and expected. And yet energy stocks have been lagging, although they had a nice rally this week. Number three, bonds are not at all serving as a buffer against equity volatility. In fact, they seem to be trading with stocks right now. Number four, Europe and Japan are hardly catching a bid either, even as U.S. stocks are caught in further uncertainties. We should at least note the relative performance of emerging markets over U.S. and European markets is one thing that we think does make sense in the behavior of investing markets so far in 2018.

Okay, well, what does it all mean? So energy stocks are a surprise. The value versus growth activity is a surprise, and equity markets behavior given currency stocks are a surprise. The value versus growth activity is a surprise. And equity markets behavior, given currency conditions, are a surprise. But beyond being surprised, what is one to do? Does the energy index performance year to date mean greater value is being offered? Or that the market knows something we do not? Are high-priced growth companies perhaps just set to permanently outperform their value cousins? Or is there more to this story that we need to act upon? You will forgive us if we confess that any investment decision that begins with this time it's different is one we permanently and unconditionally reject, sight unseen.

and unconditionally reject sight unseen. We would not dare to speculate as to what catalyst is required to see a repricing come through in value versus growth or the energy complex or energy companies overall. What we would say about these macro themes is that a disconnect between fundamentals and sentiment is not remotely uncommon and that structural realities are at play here. For example, the heavy ETF ownership of FAANG stocks, which creates a certain bid under their prices until it doesn't. The conclusions we draw that markets always and forever revert to

fundamentals and value and we see the macro environment reinforcing the outlook we have, not contradicting it, despite present pricing. So by way of recap, we see value stocks offering a better opportunity than growth as markets recalibrate to normalcy in 2018. If there's a sector whose prices do not reflect their fundamentals, we think it is the energy sector. If there's a sector whose prices do not reflect their fundamentals, we think it is the energy sector. And as investors look around the globe for a non-U.S. opportunity, we think emerging markets will offer it more than Europe. Sources of volatility versus sources of value. What is creating market volatility right now? Fear of interest rates.

Fear of inflationary pressures. The Mueller-Russia Special Counsel investigation uncertainty, probably last on the list, by the way. Concerns around Trumpian trade and tariff policy, probably first on the list, by the way. Well, why be optimistic? Business optimism is growing. We think this means more capital expenditures. Small business optimism is the highest it's this means more capital expenditures. Small business optimism is the highest it's been since the Reagan presidency. Consumer confidence is at extreme highs.

Industrial production is surging. You see my point? Economic backdrop and fundamentals very solid. The Fed is not dead. As expected, the Federal Reserve hiked rates again this week by a quarter point, bringing the Fed funds rate to a one and a half to 1.75 percent level. We suspect we're over halfway there in terms of where they'll end up considering things normal. There were absolutely no surprises in what the Fed announced, or by the way, in Chairman Powell's first press conference as the Fed chair. They have a generally more hawkish tone now and are saying all the right things about attempting to normalize and stay data dependent. Not happy anniversary. We know the housing crisis is a decade old at this point.

I'm sure some lessons were learned, though sometimes I wonder which ones and to what magnitude. though sometimes I wonder which ones and to what magnitude. But reading that 207,000 homes were flipped in 2017, the most since 2006, I cannot help but feel uneasy. On one hand, 65% did use cash to buy their flips last year, where it was just 37% who were using cash in 2004 to 2006 when bubble insanity peaked. But on the other hand, the flip number being on the rise points to something I would consider systemically and culturally that we have seen before. Stocks and bonds and their relationship. There is no better time for bonds to offset the volatility in stocks than when the pressure in stocks are deflationary. Bonds love deflation, always and

forever, but now inflationary fears can mess around with stocks too. And then bonds become a less effective hedge for stocks in an inflationary period versus a deflationary one. Essentially, the key is not to expect stocks and bonds to behave a certain way all the time, but to evaluate the macro environment that may be creating different circumstances and therefore different responses. It's not as easy as you thought, is it? The consensus view shared across nearly all pedestrian understanding of bond investing and in too many professional camps as well, is that when interest rates are going higher, the right thing to do is have lower duration bonds, shorter maturities, so as to be less exposed to rate movements. Well, fair enough,

but not quite so simple. Can short-term rates go higher even as long-term rates drop a bit? Absolutely. In fact, that dynamic of a flatter yield curve is exactly what's taken place recently, the result being lower bond prices for short maturities and higher bond prices for long-dated maturities. Interest rates being higher or lower does not give enough information to drive an investment thesis. Simplicity often trumps complexity in the investing world, but sometimes oversimplification is just flat out wrong. The reality is that from credit risk to duration risk to bond selection

to specific sector allocation, certainly to yield curve management in both tax-free and taxable bond categories, we wouldn't dream of approaching the defensive necessity in our portfolio management duties without best-of-breed professional managers, now more than ever. Did you know the 10-year treasury yield moved from roughly 2.5 to 2.9 percent, that's 40 basis basis points higher in the first two months of the year but did you know the 10-year bond yield has moved 40 basis points or more in a two-month period 15 percent of the time over the last 30 years and the average 12-month return for municipal bonds after such a period plus 3.8 percent. Speaking municipal bonds, the aforementioned flattening

of the yield curve has left long maturity bonds less attractive, created an environment where the bulk of one's bonds ought to be at or near their targeted desired maturity, as opposed to owning a plethora of maturities all over that blend together to your target average. Some credit risk looks attractive in municipal space right now, as opposed to taxable, where we think credit is a little thicker. Look, I'm out of time here this week, so I'm going to point you to thedividendcafe.com to read a good section we have on some mayhem in the MLP space and breaking down a little bit more of everything

happening in the tariff world, where we think we are with Trump. Very fascinating chart of the week about the import levels we have from China. Look, it's been a wonderful few weeks here, not necessarily in the stock market behavior, but just in terms of what I believe is happening underneath the surface. Realization across the capital markets of uncertainty to come. People being able to price in some risk that they had been ignoring in January. We feel very good about where we're positioned, I should say. But we also want to really exhaustively, if you're a client of ours, discuss with your particular situation any questions you may have.

Reach out any time. Thank you for listening to Dividend Cafe Podcast. We ask you to subscribe to it in iTunes or whatever your player is. And by all means, feel free to spread the word, write a good review. I hate saying all this stuff. It's kind of obnoxious, but we kind of have to do it. This is what helps get that traffic up, and it is beneficial for everybody. Thanks for listening to Dividend Cafe Podcast.

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