The Dividend Cafe - Tying a Bow around the Gift of February

Episode Date: March 2, 2018

This week, David L. Bahnsen reviews the volatility, highs, and lows of February in the markets. Links mentioned in this episode: www.DividendCafe.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson, founder, managing partner and chief investment officer at the Bonson Group. And we look forward to walking through some of the issues of the week in markets, kind of an ugly week, ending up an ugly February. We want to encourage you as always to check out dividendcafe.com, which is where the content for this podcast comes from. And we really want to encourage you to check out the Advice and Insights podcast, where we do very fresh content, not available anywhere else, podcast where we do very fresh content not available anywhere else, not directly taken from the written commentary, and a little more long form deep dive discussion on all things

investment and financial. So as far as this week's Dividend Cafe, we think you may very well be feeling glad that February is over. Let's talk about that. It was the worst month in markets since the ancient history of 2016. So perhaps it doesn't feel like a gift. But maybe you'll feel differently after I make a few comments here. I know that I certainly do. Yes, the extremely strong January of the year was followed up by the first negative month in markets since October of 2016. That was, by the way, the longest monthly winning streak for the S&P 500 ever. But jump into this Dividend Cafe podcast, get a better understanding of what it means. Let's start with February redux. Yes, S&P 500 enjoyed a 15-month run. In that period,

by the way, the market rallied 36% on the total return basis. Yes, the run has come to an end. Depending on the index, stocks were down roughly 3% to 4% in February after their five percent plus rise in January. All of the losses for the month came essentially in three particular days if you kind of isolate out you know all the up and down movements. There was a tremendous spike in volatility for the month with large down days and up days following each other on multiple occasions. The truly unique nature of this month's headwinds was that for the first time in what feels like forever, there's no whisper of slowing earnings behind the decline or economic distress. On the contrary, equities delivered a negative return in February because interest rates are moving higher in response to positive economic growth.

It does not make, by the way, the nature of the equity repricing less legitimate, but it does change the context when causation is actually a positive thing versus a negative thing. when causation is actually a positive thing versus a negative thing. So the first negative month in forever resulted in a market that was, well, as of the end of February, up on the year. What has us optimistic on equities? Bottom line, the money that flowed out of equity funds in February. You basically saw your first negative month of flows each and every week, negative money leaving. And that is to us the textbook definition of a contrarian, appealing, bullish, buyable signal. The take from equity bears for many years has been the idea of

peak earnings or more specifically peak margins. Essentially, the thesis was that earnings had grown in a big way as profit margins had expanded dramatically, but that as margins went as high as they could go, profits growth would taper out as top line revenues were not growing enough to justify the continued rally. Fair enough in theory, but in practice, 78% of companies beat their top line revenue estimates in Q4, the highest percentage to do so in the history of the number being tracked. Profit growth appears to be coming in at 15% year over year for the quarter, and that is pre-tax reform. A trade war by any other name depending on what kind of ends up happening by the close of business on Thursday as I'm sitting

here recording the markets technically still open Thursday. I don't know when you're listening to it and where markets are when you're listening and all that but the bottom line is the market dropped 500 points on the announcement a short while ago that the Trump administration was in fact moving forward with tariffs on imports in the steel and aluminum industry earlier today there have been whispers of it the market went back down then it came out and said, no, there's people in the Trump administration still fighting over it. And markets rallied way up. Then Trump announced that he was, in fact, doing it. And by it, I mean this utterly idiotic policy of protective tariffs for the steel and aluminum business.

So if you're a U.S. steel stock, the stock price went way higher. And if you're a customer or involved at all in the supply chain of buying steel, your stock has gone way down. And if you're at all afraid of this happening in other sectors, then the market is getting pummeled. And that's basically what we would expect. We do not see any bullish aspect to protective tariffs. That's the story of the market here on Thursday. Narratives can be wrong, or they can be really wrong. I've been critical the last several weeks of the simplistic belief that rising yields are automatically negative for the bond market.

The pedestrian assessment is that a rising bond yield makes the relative attractiveness of bonds to stocks less attractive, and therefore higher interest rates are a negative for stocks. And I've responded that this assessment ignores the other variables that need defining to make such an assessment, such as economic growth, the margin in the spread between bond yields and earnings yields, inflation expectations. In other words, we don't know enough information when we merely say rates are going higher to say that it will be bad for stocks. And as I have argued, rates going higher for inflationary reasons are bad for stocks and bonds, but rates going higher due to productive

growth can be quite good for stocks. But putting all the pontificating aside, just looking at history, I really want you to look at a chart we posted in DividendCafe.com showing the last five times, excuse me, six times that the bond yield went higher on the year and the absolutely unbelievable positive performance that took place in the S&P 500. To hawk or not to hawk? The prevailing belief in our thinking is that the Fed will be as hawkish as can be without actually being really hawkish. Hawkish means tightening monetary policy, less accommodative, less easy money. So yes, the modest reduction of their balance sheet,

behind, by the way, a total telegraphing of doing so. And yes, 25 basis point or quarter percentage point increases in the Fed funds rate one at a time, which we think will be about three this year, headed to a more natural rate. Yeah, I mean, I guess you could call it more hawkish. It's more hawkish than cutting rates. But the point is that even in this kind of sort of quasi tightening, they're still allowing a real Fed funds rate to be negative net of inflation. If the Fed proves to be more hawkish than we think, then on a short term basis, we imagine emerging markets may underperform. If wekish than we think, then on a short-term basis, we imagine emerging markets

may underperform. If we're right, we think they overperform. If the Fed's hawkishness exceeds expectations, we also think Japan will outperform on a short-term basis. So we think we have both sides covered, but, but, but there is no reason to own or not own emerging markets based on what the Fed does or doesn't do in the next six months. Same for Japan. And the same thing applies to what the Bank of Japan does and their own central bank. Our thesis is fundamental, lasting, and based on the economics of company profits, period. Always and forever. These other macro functions may affect weightings and may affect the volatility

and sentiment and certainly the noise along the way. But if we are investing in companies and that thesis is anything other than those companies, their prospects, their cash flows, their growth, and their dividend, which is the measurement of all the rest, then we're doing it wrong. The good news and bad news about REITs. We own a couple very purposely selected, publicly traded real estate investment trust stocks in our dividend portfolio. We have different real estate exposures in our alternative allocation, but it's important to clear up a misconception about REITs. One is that they're ultimately a byproduct of interest rates, meaning when rates go down, they do well. When rates go up, they do poorly. And on a year-over-year basis, in 18 years,

the 10-year treasury yield has been up year-over-year seven times. And in all seven years, the REIT index had a positive return. The worst REIT year was the year interest rates dropped the most. Take a guess, 2008. So the good news is that the understanding of REITs and interest rates is flawed, fallacious, and deeply misunderstood. There isn't a correlation one has to worry about with interest rates other than a very short-term day-by-day kind of movement. But the bad news is that the data does suggest rates are highly correlated to something, and that something is economic growth. We're willing to be invested in economic growth and to make specific selections about where there may be value and

dividend income growth in this environment. It's gotten harder, but we have to say that the notion of just assuming REITs are an inverse play on interest rates is silly. They're magically uncorrelated to everything. No, no, no, no, no. REITs are indeed correlated to economic growth. So we just believe that there is misperceptions that affect the investable attractiveness of the asset class. A glut of passivity and activity. There are 8,255 hedge funds managing 3.2 trillion dollars today that is too many a lot of them i would imagine are going to go away there's 1,831 exchange traded funds managing 3.4 trillion dollars today that's also probably too many a lot of them are probably going away but the number of hedge funds,

mutual funds, exchange-traded funds is irrelevant to most investors, as is the amount of money in each sleeve. What is relevant is their holdings, their composition, and the way the structure of the financial system may or may not affect an investor. Do unsophisticated investors panic out of ETFs and mutual funds in equity corrections, exacerbating short-term technical issues? Yeah, they generally do. Does that affect smart investors? It ought not to. Holding periods of stocks have collapsed from eight years on average to less than two years

now. Who's made the most money? Those with long holding periods or shorter ones? We hope you know the answer. It's longer. Passive, active, mutual, exchange, whatever. Own the right companies and behave smartly when things get sketchy. To that end, we work. The chart of the week this week at DividendCafe.com shows you why we believe active management is so important in the quest for dividend income and especially dividend growth. The amount or the percentage of companies in the S&P 500 offering a dividend yield higher than the 10-year bond yield has utterly collapsed from about 60% of the index to now down to about 20%.

It takes work to find these dividend growth opportunities. Last but not least, I'll close with a quote from Paulo Kelho. You drown not by falling into a river, but by staying submerged in it. We'll let you compute the application of that fine quote this wonderful week. We hope you have a great weekend. Please reach out anytime, any questions. Thanks for listening to DividendCafe.com. Please subscribe.

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