The Dividend Cafe - What is Rough and Troubling?

Episode Date: July 30, 2021

I have been thinking a lot about the stock market lately, but not for the reasons most people think about it. The most common thing people wonder about the stock market is something like this: “Is the market about to go up, or down?” I think long-time readers of the Dividend Cafe know how I feel about that question (“long-time” could mean the last two weeks in this case). I am always and forever agnostic about short-term moves in the broad stock market, not merely around anyone’s (including my own) ability to forecast such, but also around the relevance of it to one’s actual financial picture. But I hear things said about the stock market sometimes that simply concern me. I am going to address a lot of those things this week and look at some basic historical facts of the market and the environment in which we find ourselves. My goal will be to look at what does not represent a “rough” or “troubling” market environment, and what does. And in so doing, I hope we can find some takeaways about portfolio construction that speak to a present application that you will find useful. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another week of the Dividend Cafe. Those of you listening on the podcast, you don't care where I'm sitting. And those of you watching on the video, well, actually, you probably don't care where I'm sitting either, but at least you can see where I'm sitting. And those of you watching on the video, well, actually, you probably don't care where I'm sitting either, but at least you can see where I'm sitting. I am back in the Newport Beach studio, our big and beautiful studio here in our offices in Newport. I landed in the middle of the night at LAX. I've been out in New York for most of the summer so far,

primarily in the New York office and then some time out at our house with the family in the Hamptons and so kind of a lot back and forth. But now I'm out here in California for a few weeks and it's good to be not only back with our team here in California, but also back in this studio, which is such a lovely, comfortable place to record. I wrote The Dividend Cafe very early this morning after last night's flight, and I do think I tapped into something that's very important. I'll have to reread the written myself later to see if I like it or not. But here's the kind of topic I want to go through today. And I've addressed this topic in other ways in sort of recent Dividend Cafes, but I think this is kind of a different angle on a topic that's very important. I had maybe the third person this week. So when I refer to people

coming and asking me questions or saying something, there are times where it could literally be hundreds of people. And so if I make it sound like it's this huge onslaught of interest, I'm being literal. And other times I might say, oh, I'm having people bring something up and it might be one, two or three people. And so I'm probably overstating it. And that's what maybe this is. But I do think even though it was a particular incident this week of someone asking how we're holding up with these rough and kind of difficult, troubling markets, that's what sort of inspired this week's Dividend Cafe and what I'm about to talk to you about. But even though there's only been a few people that have actually

said something like that recently, I do think that there's this kind of perpetual undertone that I think there exists a belief that we're living through this sort of challenging time in the markets. And I, as I'm about to say, even believe there's a sense in which someone thinking that is somewhat rational or defensible. But for the most part, I actually think it's a case of a perception, just simply not even being close to a reality. And I want to unpack some of that and then go from there. Here's where things stand. We talk about a rough market. Some of it means like the last month or the last week or at any given week or

month, it's possible it was a rough week or month. It appears as I'm sitting here recording, we have a few hours to go in the month of July, but I think markets are going to end the month of July positive. There's been a few little ups and downs along the way and stuff, but I think markets are going to end the month of July positive. There's been a few little ups and downs along the way and stuff, but I mean, nothing, nothing noteworthy at all. But in a more seasonal sense, kind of this period of time for investors, you could argue that the financial crisis represented a paradigm all of its own. But post-crisis, we're sitting here now with 13 years, if you were to count all of 2021, where markets are overwhelmingly up, you know, high teens. You're talking about 12 out of 13 years. 12 out of 13 years that have been a positive return in the market. Two of those

were barely up. The one that was negative was barely down. So more or less, you've had 13 out of 13 years that were not problematic on a calendar year basis. You had 10 of 13 years where the markets were up a lot. You had two years where they were barely up and one year it was barely down. Okay, 2018, where you had the Feds tightening and the trade war going on at the same time and it meant we were down, you know, 4%, 5%, 6% depending on what market index. This is about as benign of a period of 13 years as equity markets are capable of giving. Now, I think what some people could mean is, okay, well, yeah, the returns have been good the last 13 years, but oh my gosh, the volatility, the up and down, the craziness. And I think post-COVID, the first thing that has to be said about that is, okay, that's true in March of 2020.

We had a 36% drop in 31 days. Now, it didn't last very long. It came back a lot quicker than expected. It came back a lot more than expected. It could have been a lot worse and wasn't. All those caveats are there. I've said that stuff a thousand times. But yeah, it was still a 36% drop.

It still had that feeling of the bottom falling out and people not knowing how low it could go. So there was that. But other than that, in 12 years, we've had, besides COVID, six times where the market was down 10% or more, all of them very short-lived. And again, the actual mathematical measurement of the volatility, it's a term called standard deviation. It refers to the variability of the average return around its own mean. So the average return and the variability of that up and down refers to volatility, refers to standard deviation, if I could be technical and mathematical about this. The markets average something over 15% average standard deviation for 90 years, and it's been like 13% since the financial crisis. So you've had above average returns

with virtually no down periods of note with below average volatility. So the rough and troubling stock market has actually been not rough and not troubling at all, measured by the things that generally matter, the returns, the volatility, and then the severity of the downturns. That one COVID month being a noteworthy exception. Now, fourth quarter 2018, we were down 19.8% for a brief period of time. It didn't last long. The summer of 2011, we were down 19.9% for a brief period of time. It didn't last long. The summer of 2011, we were down 19.9% for a brief period of time. It didn't last long. The flash crash of, let's see here, May of 2010, we were down 9.something percent in a very short period of time. That lasted a few hours.

So there's volatility, but it's nothing outside of the historical average. And again, it's actually less than that. So what does one mean by rough and troubling? I think most people actually do mean that. And I think they're wrong. I think they do mean troubled returns when it hasn't been. And I think they do mean troubled volatility when it hasn't been. But there is a sense in which one could use the terms and mean something that I think is closer to legitimate or accurate. And that is the kind of valuation dynamic that we're in. The concern about,

hey, I feel that we are investing in an expensive part of risk assets, late cycle. There's something troubling about that. There's something rough to this decision making. I get that. And I'm going to have more to say on it in a moment. But I think fundamentally, most listeners and most people who follow Dividend Cafe, certainly most clients at the Bonson Group know how I feel about that. My goal is to avoid the things that I believe are excessively valued. My goal is to not view valuation as itself a timing tool, for it most certainly is not. And my goal is to avoid the alternatives that are to such a valuation-based metric that are worse, meaning someone saying, I'm going to the sideline,

I'm going to stick it out in cash and wait till valuations are cheaper, whereby one could theoretically be in cash for 10 years and ruin their investing life. You take away 10 years of compounding returns for any investor, and I promise you, it's suicidal? So because we take a do not blow up mentality to invest in client money, do not do anything that can jeopardize survival, whether it's excessive risk taking or the lack of risk taking that both lead to the same thing. And what does this blow up? The mathematical incapability of achieving your goals. That's what we're trying to avoid. And you can easily do that the other way. Obviously, excessive risk, excessive leverage, a big misguided bet, and it blows up. That can

blow one up. And you cannot recover when you're dead. Stop me if I need to repeat that. So we know we want to avoid that. But see, I think the same thing can happen on the other side too, where one can say, I'm out on the sideline for 10 years. And then they literally, first of all, if they're withdrawing from their portfolio through that period of time, let's say they're a retiree, they can run out of capital because they've eroded their principal so significantly. And even if they have so much money that their withdrawal base allows them to do so, so they haven't blown up, but they've just permanently eroded and destroyed capital that now they cannot leave to their heirs or to their charitable beneficiaries.

So I don't view any of this as really pleasant. I think that the valuation problem is a problem, and I've already kind of addressed how we feel about that. It's a bigger problem for index investors. It's a bigger problem for those not asset allocating. And it is a really, really big problem for those who try to convert that into a market timing approach. But what I would say about rough and troubling is not the return environment we've been in, which has been benign. It's not the volatility environment, which has actually been slightly less than normal. And I'm not even really referring to the valuation dynamic, which by the way,

if I were, I would not be referring to stocks. I'd be referring to bonds and then stocks. Because what you have right now is a 1.25% 10-year government bond yield, where we have been below 2% for 4% of the time the last 100 years, all of that basically being in the last few minutes. Okay. Let's say that in a way that makes a little more sense. We've been above 2% for 96% of the time the last 100 years, a good portion of that, you know, back in the 7, 8, 9% range, let alone the 4%, 5%, 6% range. So now with these bond yields so low and the price of these bonds so high, you're talking about a couple standard deviations outside of their normal valuation bandwidth. Equities are stretched, but not to

that degree. But I think that what we have in a rough and troubling sense is this thing I talk about over and over and over again that I obsess with. I don't want to say I worry about it because worry is not the right word. It's just more that I'm keenly aware of, that I'm focused on. It is the unprecedented level of monetary intervention in financial markets. We have a central bank. We've had a Federal Reserve since 1914. We have a Federal Reserve that has viewed itself as a coddler, a soother of risk assets. And we've had that for quite some time. But we have it right now in a way that we've never had it before. And I've talked a lot about some of the things that I believe are concerning, where you've always had this federal funds rate, the ability to lower the interest rate to try to stimulate

either economic activity or provide a boost to financial markets. Now that we've gotten to the lower bound, and in this case, the zero bound of that interest rate level, you've taken away a policy tool that you can use for defense in the future. That's a problem. That's an unknown. It's a problem. That's an unknown. It's a risk. But even beyond that, there is just the unknown dimension of what to do with a balance sheet the size of the Fed. The probability, not certainty, but the probability more than

possibility that they may not ever lower that balance sheet or ever lower it by much, certainly not back down to the levels that we were at pre-COVID or let's really talk sensibly here, pre-financial crisis. Okay. Somehow the Fed balance sheet made it for many, many, many years with hundreds of billions of dollars. Now it's up to 8 trillion. And so I cannot tell people, well, this is going to mean this or this is going to lead to this bad outcome or this is going to lead to this good outcome. This is also unprecedented. We don't know. And so I have to avoid one of two mistakes here. One is to say because it's unprecedented, all bets are off.

Everything that happens is one degree or another is unprecedented in markets. Markets are in a lot of ways the historical unfolding of unprecedented events. Everything that is happening is generally unprecedented. Some things have more of a connectivity to past history than others. But my point is that geopolitical events and certain macroeconomic events, markets are themselves this highly complicated force of discounting in the reality of unprecedented events in history and events in economics. I think that the unprecedented nature of the Fed's activity right now is a bit different

in that you're getting to the heart of the prudential management of the economy. of the prudential management of the economy. And the more intervention that has come in to financial markets, the more destabilized financial markets ultimately are. And so you get a diminishing return on what stability the central bank can bring to things at a time when people are more and more dependent upon that central bank for bringing stability. more and more dependent upon that central bank for bringing stability. And so this is, to me, a rough and troubling part of being an investor right now. Those adjectives, I think, can be appropriately used to describe that reality. Not so much to describe just the mere nature of markets going up and down and whatever is going well with earnings this quarter or poorly with COVID

and policymakers another month and all these things. At the end of the day, right now, my view is hyper-fundamentalist. I think that the greatest path through the unprecedented and uncertain reality of what we deal with with the Fed, with these interventions, with how this could unfold. And I don't mean unfold in the next three to six months. I don't care how it unfolds in the next three to six months. I mean potentially for decades. And a lot of people I'm managing money for, I'm managing it for decades. The stewardship over my own family's assets and whoever manages my family's assets when I'm gone, I certainly hope that to mean decades. And so these are long-term macroeconomic things, applications, principles.

And I believe that we land squarely in a position of saying, A, the view of bonds in that portfolio is different. And if it comes back to normal at some point, great. I don't see how it can, but maybe it will. But the way in which one views bonds at a 1% or 2% 10-year is different than you're going to view them at a 4%, 5%, or 6% 10-year. It's just math. And it's more than math because it speaks to that math came about because of the economics, because of those downward pressures on growth expectations that are embedded and signaled in the bond market. So I view it as reconfiguring the way one sees bonds with a heavy buildup around dividend growth equities as a core base of a portfolio to capture the risk reward paradigm you're after, using alternatives to

right-size the risk reward to kind of replace some of the bonds, to diminish some of the equity beta, to try to replace some of the market risk with manager risk and yet nevertheless achieve a risk-reward paradigm that is attractive and appropriate for a given investor. To look at credit for the risk asset that it is, be appropriately allocated to it but not with the belief that there is not such thing as credit risk. To understand, manage and know the credit risk. there is not such thing as credit risk, to understand, manage, and know the credit risk. And then to have expectations appropriately set, to not believe that 10% per year, always and forever for equities is a birthright. It is not. It will not happen. There will not be a linear dependable return from broad equity indices of 10% a year. It could be lower, it could be higher, it could average what it's going to average, but it will not be linear. So getting expectations

set right and then monitoring appropriately, not simply relying upon PE expansion, not simply relying on yet another Fed trick or yet another fiscal spending bill, you know, really doing the work necessary to get a return from one's financial assets that is rooted in the fundamentals of the underlying investments. That's what we're here to do. That's what we do. It's not rough or troubling. It's just a job.

It's a passion. I love the job. I wouldn't want to do anything else. No one on my team would want to do anything else. This is the life we chose. I wouldn't want to do anything else. No one on my team would want to do anything else. This is the life we chose.

But that's what I think about this rough and troubling market is that we live in a period of time, and I plan to be investing client capital for the rest of my career in a time where the Fed has an unprecedented intervention into the economy, and therefore that leaves unknowns out there for us to manage with. And we manage it with a tool of dividend growth, with proper understanding of fixed income assets, and with the addition in our toolbox of alternatives that we think can help right size the risk and reward of the portfolio. That's our job. So I hope this all makes sense. There's some really great charts, long-term equity returns, various aspects of the bond market that are in DividendCafe.com this week.

Please check that out. And then our chart of the week speaks to the just absolutely, totally collapsed level of velocity. The M2, which is the measurement of the money supply. Everyone's talking about the higher money supply we've gotten with all of the Fed and fiscal, congressional, treasury department activities the last couple years. Money supply has absolutely grown and the velocity has totally collapsed, but not just collapsed in the last year, collapsed in the last 25 years. And this is not the problem that we deal with. The low velocity is not the problem. The low velocity is the signal or sign of the problem, which is a fundamental

imbalance in the economy because of excessive indebtedness that leads to declining expectations of growth and therefore intensifies our need to provide fundamental driven investments, cash flow generative, cash flow growing investments that can meet investor needs. So check out DividendCafe.com, rate us, review us, subscribe to us, blah, blah, blah. Thanks for listening and watching the Dividend Cafe. Reach out with any questions anytime. Hope your month of July has been a good one and look forward to jumping in the month of August. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC.

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