The Dividend Cafe - The Volatility Virus and Cure

Episode Date: January 31, 2020

Topics discussed: On Friday the regular Dividend Café for the week went out, and it included as much of an update as possible around the UK elections and the China trade war … But within hours of the submission there was more news, and then the next day even more, and then over the weekend even more still. I don’t want to wait until Friday to provide the latest and greatest … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Thursday, as opposed to early in the morning. So we have a little bit better feel for how Thursday is going to end up. And then, of course, by the time you get this, we'll see where things are Friday. For a long time, that hasn't mattered. We've had a pretty low volatility run here for a few months. But this week, we've had some volatility return. And that's going to be most of what I talked to you about here today. Obviously, those that are turning on the news or paying any attention have heard all the talk about this coronavirus. And I do think that a significant amount of the volatility is a result of enhanced uncertainty out of the health epidemic taking place in China. But I'm going to kind of make the point here today that it may not necessarily be

all about coronavirus and investors would be unwise to assume that everything is kind of make the point here today that it may not necessarily be all about coronavirus and investors would be unwise to assume that everything is kind of packaged into one lane here. So yeah, we're going to talk about this week in the market. We're going to talk about coronavirus, talk about the way people want to treat it, kind of have a little refresher and a couple of very, very important first things. I'm going to dive into a little economics, talk venture capital, pharma. I'm going to cover about 10 different things. I'm not going to talk about the impeachment because I don't want to, and there's nothing to talk about. Let's see here. Late Thursday, market's down a little over 100.

The market's been up or down over 100, you know, triple digits every day this week. Even one day where it didn't close that much, it had intraday volatility that way. But we started off down 400 Monday, then we're up a couple hundred Tuesday. And you've just had up and down movements each day. When all said and done though, we are off of our highs from earlier in January. At one point, the market was up over 2% on the month. And we may end up closing the month even. We may even end up down a little. We may end up up a little. It's really close and we still have one trading day left by the time you're listening. So I think that obviously we've had a little volatility come back in, but I don't want to be dishonest and pretend it's something it isn't. days is hardly newsworthy, and particularly when it comes in the backdrop of that 3,000 point move higher that the Dow had enjoyed throughout the fourth quarter and into early January.

Earnings season, though, is going to become an issue, and we've started to see it. And I'm going to hold back a little this week because I want to have more data to give you next week. As I'm here talking today, Thursday, just today alone, nearly 10% of the companies in the S&P 500 are reporting. And by this time next week, another 40% will have reported on top of those that already have. So you'll really get to the vast majority, roughly 70% of S&P 500 companies will have reported by next week. So it'll give me a little bit fuller representative sample of data. But the theme I'm seeing so far, and I don't know, this could change. I don't think it will. You're having companies with pretty noteworthy misses,

disappointing numbers that are getting slacked, and you're having companies with big performance, big forward guidance, optimistic outlook that are really rallying hard. And so you have pretty big moves post earnings announcements. It's just that the move could be really to the downside for one company and really significantly the upside for another. So that's that high dispersion of return that we always talk about. And I think you're seeing it, including with some of the top companies in the market, even here over the last several days, one of which was up big and one of which was down big in the aftermath of their earnings. So you take the earnings environment

with some uncertainty around that and the kind of high dispersion of results, you get a little volatility there. And then you look to the coronavirus story. And our investment committee did a full podcast a few days ago, kind of a special edition. And I don't have a whole lot to add to it. There are more known cases now. There are more known deaths, unfortunately. But the themes are all still the same. That is that China is doing a lot to try to contain it.

It's a very categorically different response than we had from the SARS outbreak in 2003. And I believe you have to kind of look at it around what the economic impact will be more than the health impact, because I think the health impact, they're going to end up containing it. It won't break out into a global kind of influenza, so to speak. And yet, you know, from a human standpoint, the difference between 100 deaths and 500 deaths is a lot and awful. And so you obviously have to pray for an immediate recovery and solution from the kind of health and sciences aspect. But ironically, the worst thing that may end up happening on the economic side is what could be the best thing on the health side, which is that China's just got a complete lockdown around this, which is so different than where they were with SARS. So they've now effectively kind of travel blocked 50-something

million people in the town where this is sort of outbreak, where the outbreak took place. Do I think this will lead to a reduction in technology activity. Well, I don't, but let's say it did. I can't make any argument for why that wouldn't just simply get caught up once it ends. So if someone's going to order X and then they ended up ordering half of X, you end up getting double X later, right? To make up for what was the lost transaction during this interim period. The same cannot be said, though, for tourism. It isn't like someone plans a trip, it gets canceled, and then they end up doing the trip later.

Maybe that could happen, but for the most part, that represents sort of lost revenue that has sunk and permanent. So, yeah, to the extent people were real heavily invested in Chinese tourism, I would argue this is a material problem economically, although I would probably have said that investing in Chinese tourism may not have been the lowest hanging fruit in the opportunity set of investing to begin with. All that to say that this has elevated noise. There is a lot of media malfeasance going on, and I harp on that all the time. But that, I think, is my sworn moral duty to constantly point out when maybe things are not necessarily aligned

with your own interest in coverage of them. But that's different than saying that there isn't any risk around it. I do think that there is going to be some enhanced volatility, and it's going to end when it ends, and it is going to end. And from a fundamental standpoint, it is creating sentiment headwinds for emerging markets, which we love. It represents a great buying opportunity for things that we think were already undervalued. But then you have to ask the question, wait a second, are you possibly exposed to false signal here? Like, is there any chance that the market was selling off and it isn't fully related to coronavirus?

There's no question that plays in. Is it half of the reason? Is it 90% of the reason? Or maybe even less than half? I think that there is potentially other factors going on. You do see very progressive Bernie Sanders climbing in the polls. That enhances some of the election fears. Bernie Sanders climbing in the polls that enhances some of the election fears.

It's what you call left tail risk, low probability, high magnitude events that can be very disruptive to markets. But they right now have plenty of possibilities out there for these kind of things. Whether it's Bernie or whether it's fear about the Fed, whether it's coronavirus, those tail risks are there. You can't form an investment policy around tail risk. You can only, and this is the great reminder I want to give you, you can only do asset allocation. This is why we have bonds and alternatives in a portfolio, because you're worried about low probability, high magnitude events.

And so to the extent that bond yields this month have really dropped quite a bit, pushing bond prices higher, asset allocation is doing what it's supposed to do, which is neuter some of that volatility that takes place when you have disturbing events such as coronavirus or what have you. Now, what would I say is the main thing we are focusing on or thinking about when you have this little escapade? move higher in a couple months before and treat it as if this is a really material significant event, which it is from a health standpoint, but it's not from a market standpoint yet. The reason I'm saying this is because I'm reminding everyone before it becomes the meaningful market event or before the next meaningful market event happens. Because this

lesson, this truism could be about coronavirus right now, and it could be about something else in a month or three months or six months. But this is for those people interested in the philosophical orientation of equity investment at the Bonson Group. This is what we're doing. We are asking ourselves investment by investment on stocks and companies we own. is this above average dividend that we're getting sustainable? Will it continue to grow? And that's it. So we do not think very many people are asking this question. We do not think that that is the prevalent understanding. For some reason, unbeknownst to me, there may be people that think they could trade around what's going to happen with coronavirus. They're going to be buying here and selling there and really timing all this ins and outs around what they think is going to happen on a global health matter. It's not just arrogant.

It's so stupid. I don't even really know what to say about it. If one feels, yeah, but there could end up being 7% downside volatility. Well, that's right. But nobody should be having equity investments in their portfolio if they can't handle 7% downside volatility. Well, that's right, but nobody should be having equity investments in their portfolio if they can't handle 7% volatility, let alone across a balanced, diversified portfolio. So the asset allocation hedges a lot of it, but then you have to look to what the long-term objective is. Are you trying to get income out of your portfolio?

Is the income being threatened by things going on? The answer has surely got to be no. And you want future income. You're reinvesting these dividends. And the question you have to ask is, are those dividends sustainable? Do you own quality enough companies? Is the fundamentals lined up with the sustainability of the dividend? I think that this question transcends the highly transitory events that most investors are wasting their lives or at least their money trying to answer. So between asset allocation and a focus on continued sustainable dividend growth, you know how we're thinking.

And this is not going to change. And I do believe we're right. I do believe it's the right thing to do. But one is free to disagree. I just am not willing to portray our emphasis as anything other than what it is. A little economics tutorial because this is actually the stuff I love talking about most. I think that the most important conundrum for investors to solve right now is whether or not growth can be sustained in our economy by just increasing leverage.

Okay. And so we know the answer is no. So the question then becomes if corporate America can't lever up much higher, governments can't lever up much higher, well, how much of the current growth that we're getting is in fact a byproduct of only rising leverage versus how much of it's organic and healthy. And I'm not in this really negative camp that thinks all of our growth has been purely leverage driven. I think we've had very organic growth and in fact, very sustainable growth.

It's mostly been healthy. No question some of it has been dependent on either companies or countries taking more risk on their balance sheet. But perma-bearers do something that really frustrates someone like me. And it frustrates me as much for the partially accurate implications in it as the blatantly dishonest ones. And that is that they make claims that no one would disagree with. Like, oh, the Fed's played a huge part in reflating the economy. Fair enough. Leverage is increased because the Fed made it possible for that to happen. Okay, obvious. And then the other aspect is stating the bad consequences await if the Fed shuts down the credit pumps that they've made the economy dependent on. Well, that's something I've been stating over and over and over again. It's something we went through in the fourth quarter of 2018. They're all true enough. However, the question is whether or not those things tell us something about what we need to be doing within our investment portfolio

right now. Because people do not know when or how the Fed will alter the landscape. They do not know what other facts will enter the fray along the way that kind of end up changing the future situation for good or for bad. We don't know what we don't know. And so our goal economically is to recognize that leverage-dependent, debt-dependent growth ends at some point and usually does not end well. Recognizing that even though people love it when the Fed intervenes to assist markets, that the unwinding of that assistance can become difficult and frankly, it can become impossible because there's no political will to go unwind something when it's going to cause pain. They view their job as to always make things feel good. So if you make everyone feel good by doing something, undoing it's going

to create pain and there's no appetite to doing it even when it might need to be done. And that's really the point I want everyone to understand. We have a very accommodated monetary policy right now. It was clear from hearing Chairman Powell speak this week that's not going to change anytime soon. But the reason we have an accommodated monetary policy right now is pretty much because we used to have an accommodated monetary policy, meaning we're stuck with it. We had one, and so now we have to have one. And they got a chance to taste what not having one might look like to some degree, and no one liked what it tasted like. So that's where we are. might look like to some degree and no one liked what it tasted like. So that's where we are.

Delaying and deferring is not the same as avoiding or averting. In other words, there are pains that are likely coming and all they can do is defer them. They cannot make it go away altogether. And yet in that, we don't know how it plays out and when and what it looks like. This is the turmoil and the uncertainty that I think is, first of all, part of the deflationary spiral global economies are going through. But second of all, the challenge that we have to have in the way we allocate capital for clients. So I did mention I was going to talk quickly about pharma. Just want to point out that it seems to me we're getting more and more bipartisan by

the day, certainly very in line with what you would expect from a campaigning incumbent president who's talked a lot about this issue, that there's going to be some kind of a drug price issue coming down the pike. And because it doesn't appear that there's going to be bipartisan agreement as to what that ought to look like at a congressional level. Mostly, I think that no one wants to give the president what would be perceived as a political victory. And before you think I'm blaming on the Democrats in support of the president, I vehemently disagree with what the president wants to do here as well. But my point is that what he wants to do probably is good for him politically, even though I disagree with the policy. And I think the Democrats don't want to give that political victory. So what we are hearing more and more in studying is that the best option

he has is to impose by executive order, some sort of indexing of pharmaceutical prices to an international pricing index. And the question becomes whether or not that would be applied in Medicare to Part B, which is much more broad, expansive, and covers a wider terrain of Medicare patients, or in Part D, which is a more niche, very specific drug customer under the federal entitlement. So the only thing I can say when people go, why don't you just sell the drug stocks? Obviously, this is going to be bad, is this has been lingering over the drug sector for years, very specifically and actionably for the last

couple of years. And yet the bulk of the industry, biotech and pharmaceuticals still perform just fine. So we see distortive interventions coming. Details are going to matter and we're still having to watch for the details. I have a piece in dividendcafe.com on venture capital. I was largely inspired by it after a pretty lengthy article I read last weekend that I thought was very interesting. But to the extent that there's always, especially here in the West Coast, Silicon Valley, you have all this kind of interest in the great venture capital success stories. I do think that the little paragraph or two I have in DividendCafe.com is worthy of your attention to understand what it sure seems to me is a new paradigm for VC, for venture capital going forward, largely because of where private equity is, largely because of the risk-reward character that has proven to be true in venture capital.

The very asymmetrical risk-reward is not scalable the way private equity is. And the venture capital of the 1990s appears to me to be very dead and gone. By the way, our GDP number came out this morning. Real GDP, meaning net of inflation for fourth quarter, grew at 2.1%. We had projected 2.2, but most economists that were kind of more negative on the economy in recent weeks were saying they thought it would print around 1.5%. So you basically now for the three full years of the Trump administration have had 2.4, 2.9, and now 2.3 last year net of inflation. So averaging over 2.5% per year, pretty significantly higher than where we had been in the years prior. per year, pretty significantly higher than where we had been in the years prior.

Although I would add, I think that that last year's number would have been half a point more had it not been for the trade war. No big surprises from the Fed this week. People are a little worried because they've seen some of the balance sheet come down this month. But I think that's more technical as the demand for repos has gone lower and Fed activity in that temporary liquidity vehicle of the repo repurchase agreement market is lower. But they are, of course, buying more T-bills to build up those excess reserves and keep their balance sheet higher. And that is permanent liquidity. So yeah, you've seen a little bit of a drop in temporary liquidity, but a big increase coming in permanent liquidity. People can talk about this interview, which angle they want. And I think half of you right now are saying, what is he talking about? But the reality is at the end of

the day, it's a huge subject if you actually thought the Fed was looking to constrain liquidity. In fact, we think they're looking to do the exact opposite. My belief has been all along this year that the Fed would sit on their hands. I continue to believe that's true. If they were to do something, I think it would be in cutting, not in raising, based on the election year and so forth. But I got to say, seeing this yield curve re-flatten to a point where that three-month and the 10-year, which were uninverted by about 20 to 30 basis points, have now come back to very close to one another, I could see potentially the Fed feeling they need to cut again just to lower that short end of the curve. I don't think what it can do, I have a line in Dividend Cafe, I say, let the

string pushing continue. I don't think that there's much they can do about it because the problem right now is the long end of the curve coming down. Previously, they had pushed the short end of the curve up. And so that's why people are saying it was Fed policy that inverted the yield curve. And I think that was largely true. But now for them to try to lower the short end of the curve, it doesn't address the longer term problem, which is secular, which is structural, which is that there's not enough confidence in long term economic growth with such a debt ravaged society to see long term bond yields be much higher. not talking about impeachment. All you really had this week outside the impeachment trial was the passage of USMCA, which is the so-called NAFTA redo, and pretty good political victory for the president. Just the fact that it was done legislatively, there's been prison reform and tax reform, and then now this, and this was much more bipartisan than tax reform. But you're

talking about one piece of legislation getting done per year right now. So that in and of itself is kind of meaningful. But I suspect it would be politically advantageous to the president to have gotten this done. Chart of the week at DividendCafe.com. We have a little repicture of the Fed's balance sheet, their mad scramble to add more liquidity. And just a reminder that we are dealing with real GDP growth of over 2.5% per year, unemployment about 3.5% a year, wages growing over 3% a year, and yet unprecedented levels of monetary accommodation. yet unprecedented levels of monetary accommodation. I hope that for those of you who understand what I mean by this, you are resolved to the fact that Fed accommodation and easing a monetary policy is not even close to being an emergency measure anymore or something to do when there's a crisis or a recession. It's just common. The default position is monetary ease. If you don't know what that means, I hope you'll find out what it means.

Because what it means is that there is more distortion and more opportunity for volatility around a Fed that is highly engaged and intervened into markets. But do you want to bet against that? Don't fight the Fed trade. But do you want to bet against that? Don't fight the Fed trade. When you look at the chart of the week and see that kind of V-shaped move higher in the Federal Reserve balance sheet, the amount of liquidity excess reserves they want in the banking system to try to spur economic growth and influence asset prices, it's very difficult to take a high conviction against it. So here we are, higher levels of volatility, right coming into the

beast of the belly of the beast of earning season, coronavirus lingering. Now we're going to go to Iowa on Monday night, caucus a winner there, and then have a primary in New Hampshire eight days later. Will that create more ambiguity about where the Democratic primary is going or will it resolve it? We shall see. But there could be a little market impact around that as well. That is my weekly Dividend Cafe, covered a lot of ground. Please do read the weekly Dividend Cafe. And more than anything else, go review this podcast, give us some stars, do whatever you want to do, but send it to us and we will send you a copy on us of my new book on Elizabeth Warren's economic policies as our little treat. And thank you for listening to The Dividend Cafe.

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