The Dividend Cafe - The Tug o' War Between Earnings and Bond Yields

Episode Date: April 27, 2018

This week, David covers ..... Topics discussed: Earnings Rising Long Term Interest Rates Political landscape and the market Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. much now to talk about how the market will have closed or where it is or whatnot when things are still open because we record this and then who knows what happens in an hour, let alone a day or two. But it's been a really interesting week and that's what we're going to spend our time talking about today. What has happened this week and why? So as I'm sitting here talking with roughly an hour to go in market trading on Thursday, markets up about 275 points today. And it was kind of flattish a couple of days this week, and it was down well over 400 on Tuesday. So we'll see what ends up happening both end of today and, of course, into Friday.

And a lot more companies are announcing their earnings results after the market today and Friday morning. So it's entirely possible the market ends up on the week. As of right now, it's down a little, but not nearly as much as it had been a couple of days ago. And so with President Trump and tariff trade talk out of the headlines, which is previously causing 500 and 700 point down days, then up days and so forth, With that somewhat neutered for the time being, what is causing the market to drop four or 500 points in a day when earnings results have been absolutely stellar and what's causing it to rebound a few hundred points two days later?

Well, this is the most important thing I can explain right now that is governing the vast majority of market action. First and foremost, it is not a story about the E, the earnings. When you talk about the P-E, the price to earnings, the E is that denominator that is based on the profitability of the companies in the stock market, profitability of the companies in the stock market, 86% of whom thus far that I've reported have beaten their earnings expectation, and over 65% have beaten their top-line revenue expectation. There's really no aspect of earnings season so far that is disappointed. What we would have thought we would see, hoped we would see. Some companies have done better than expected, some companies a little worse, and that's the way these things

generally will go. But what you see creating enhanced volatility is a foundation of enhanced volatility created by skittishness and vulnerability when the Fed has taken a step back from supporting risk assets by slightly higher interest rates, stated verbalized inclination to continue raising rates a bit, and the fact that they're reducing their balance sheet. So you have this sort of understanding that there's a little bit less of central bank support, nothing unexpected, nothing grave, but the general vulnerability created by the lack of that Federal Reserve intervention. And then you add on to it the general foundational environment of questions about Trump tariff trade

issues. We've talked about that ad nauseum for the last couple of months. And then you have the vulnerability that comes from the fact that many are expecting, I think probably correctly, a blue wave in the Democratic results from our midterm elections. Very possibly, if not likely, I would say likely, that the Democrats will retake the House, probably not the Senate. But either way, the understanding that there's a little changing of the guard around the makeup of the political landscape. All of these things create this sort of skittish vulnerability. But then fundamentally, the earnings have been very solid, growing, and revenues growing, and overall economic backdrop very supportive. But when you take the rising interest rates, not the short-term rate the Fed

controls, but longer-term bond yields moving higher, the rates that we would use to discount and measure and evaluate and contrast the earnings we're buying from the S&P 500, then what you have is a rising denominator, but a discount rate that is going higher, making those earnings less valuable. So it sounds very complicated, and I understand, but I don't really know how to make it much simpler. It is an extremely simple but important concept that sounds more complicated than it is. extremely simple but important concept that sounds more complicated than it is. The longer term interest rate going modestly higher causes investors to pay a slightly less for earnings. Now, I have said and am adamant in this proclamation that a 3% 10-year bond yield is

not ultimately bad for stocks. It is indicative of a growing economy, and it is, in fact, a historically low number. However, if now sitting around 3% on a 10-year bond yield, and we're exactly at 3% as I talk, if the fear is we're going to 3.25 or 3.5, it's the fear of it worsening, impacting sentiment around stock market valuation. It is not the number itself that we're sitting at now. We're of the opinion that some of the disinflationary forces have not necessarily changed. Hyper indebtedness of a lot of the developed world economy, the globalization, the automation, technological advances. These are disinflationary forces in the economy. And we don't believe that you're

going to get the inflation necessary to see a sustained bond yield back near 4%, let's say. I'd love to see enough growth to get the bond yield back there, but I just don't believe it's going to happen. But I can understand why markets have to respond in a volatile manner, considering those foundational things I already described relative to the big picture of what's going on. So there is a tug of war of forces. There is the positivity of growing corporate profits up against the negativity of weighing those profits versus the bond yield. And I would love to say that there's something else going on, and I'd love to say there's something even simpler going on, but that is what is going on. That's the force that we're kind of dealing with and evaluating and handicapping and modeling at the Bonson Group right now on a daily basis, making both asset allocation decisions and security selection decisions around it. What types of stocks are best to buy when the headwind for markets is a declining P.E. ratio driven by a rising bond yield? It's more fairly priced stocks.

The very high P.E. stocks are the ones that are most vulnerable. So growing dividend names with good value-oriented valuations are the sweet spot we believe investors want to be in right now. So that's sort of the message for this week, if you're trying to get your arms around the volatility. The markets could be pummeled if they had a disappointing earnings season. An awful lot of optimism was baked into what would happen in earnings. But that optimism has so far been playing out. We're only about a third of the way through earnings season. So the remainder of this week and on into next week is the real heart of the matter there. But I think the market feels pretty confident in how those things will play out. So that's the lay of the land. Expect continued volatility. That thesis has not changed.

Expect continued surprises from more small and mid-cap names. We're very pleased with our emphasis there. Emerging markets, and to some degree, Japan, have really continued to stay kind of outside the fray of what is weighed on U.S. equities. And we're very pleased with our asset allocation decisions there. And then from a bond standpoint, just understand that the bond market is trying to price in some different forces and realities than it's been pricing in. And the bond market rules the world, as a famous political pundit once said.

So anyways, I'm going to conclude us there, get back to work here. We'll see where things end up pricing for the week and come back to you more next week with a greater assessment of earnings season, the economy, the interest rate environment, bond yields, you know, all the stuff that really excites you. Thanks for listening to Dividend Cafe, financial food for thought. The Bonsai Group is registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors LLC, a registered investment advisor of the SEC.

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