The Dividend Cafe - What To Make of This Market Correction

Episode Date: October 26, 2018

Topics discussed: Why Are The Markets in Turmoil? When does the high Debt-to-GDP ratio become a problem? Why are U.S. monetary conditions tightening? Links mentioned in this episode: TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. We are recording Friday morning. Markets have just opened and it has been a whirlwind of a week. It's been a whirlwind of over two weeks now. And you had a big, big drop on Wednesday of this week, a big rally on Thursday. Now another drop Friday's net net pretty significant down on the week, pretty significant down last couple of weeks. Think about this little stat. 14 days ago, the market was at its all-time high. And now we're sitting here talking about correction mode and others wondering about bear market and all this stuff. So

that's the way the cookie crumbles, so to speak. I'm going to just spend our time here today trying to give you a nutshell. I'm going to play off of the dividendcafe.com written version to give you kind of a little breakdown as to where these tensions in the market exactly are coming from. You know, the fact that the bulk of this drop is in the higher risk segments of the market, the higher octane, growthy, high PE ratio, high volatility, high momentum areas is relevant. And yet it doesn't mean that we're not in a broader risk-off sell-off at the moment, but the NASDAQ is getting utterly decimated. The FANG stocks have been just murdered. Small cap has had its face ripped off i'm running out of dramatic analogies to uh verbalize how how violent it's been in some of those areas quite a bit more muted i think in and shall we say

the more value-oriented um defensive areas of the market even as uh i'm recording right now utilities are actually up on the day. A couple of the consumer staples and pharmaceutical names are up, even as the market's down a couple hundred points. And that was the case Wednesday, too. You had the market down over 600 points, and yet you had a handful of real defensive names, blue chip type Dow industrial names that were up on the day. So let's see how today plays out because you may end up, I believe this would be the 13th out of 15 days, maybe 13 out of 16 if we're down today that the S&P 500 has been down,

which is just crazy. But let me kind of break things down here as to what is going on. There's two things I want to explain, and they're actually quite correlated to one another. Underlying the current market conditions are two different realities. Number one, weak global economic conditions underpinned by a fear of the trade and tariff realities with China. And number two, tightening U.S. monetary conditions, which happen to be going head to head with the reality of number one. So to repeat, weak global economic conditions going head to head with a tightening U.S. monetary environment. Why are U.S.

monetary conditions tightening? The Fed is slowly but surely working to get the Fed funds rate to the neutral level, meaning to that neutral place at which the short-term rate would be without intervention. That number is likely between 3% and 3.5%, and they're at 2.25% right now. So they still have roughly four more rate hikes if they go a quarter point each to get to that quote unquote natural rate. Any rate beneath that is still considered accommodative policy, stimulating an economy that doesn't need it. And any rate above that would be tightening. The process is better called normalizing, assuming that they stop at a neutral rate level, by the way. The reason for doing it is twofold. A, they need to have bullets in their gun for when, not if, an economic contraction comes.

And B, they need to try and slow down what could be excesses building up in the credit market. Well, what do you mean excess? Perhaps the major theme that I took home from my recent New York due diligence trip, which I talk about more extensively in our Advice and Insights podcast this week, is the reality of credit market conditions. The investment grade credit market has grown by $4 trillion since 2009. Middle market lending has grown by 131%. The portion of the investment grade market that is filled with triple B rated bonds has grown from 32% of the market to over 50% of the market.

from 32% of the market to over 50% of the market. Leverage ratios have gone from two times to two and a half times debt to EBITDA. Coverage ratios have come in from nine times to eight times, meaning your interest coverage from profits. Debt to EBITDA ratios in the S&P 500 are above pre-crisis levels. So the data points go on and on. I think I just sort of cherry picked six or so of what I consider to be the more impactful points that I would make. Listen, credit markets are not bursting at the seams,

but none of these numbers can be viewed any other way as headed towards something problematic. They're not catastrophic. They're not, you know, nail all your furniture to the floor type numbers, but they're reflective of a credit market where quality is deteriorating. And that matters when recessionary conditions surface. For now, the U.S. economy is humming along, but no, the reality of business cycles has not been replaced, and the fear about credit frothiness is not about the present tense, but the future tense, when economic growth slows down. Corporate balance sheets have re-levered since the financial crisis, and that was all done by design. The Fed went on a mad mission to add liquidity to the economy. Well, mission accomplished. Now that liquidity is sloshing around, and much of it productively so, but risks have been heightened,

and the Fed wants to rein in what could become problematic. Well, where does this global stuff come in? The problem with the U.S. economy performing better than the U.K., than Europe, than Japan, than emerging markets, is that at some point the divergence becomes unsustainable. 43% of S&P 500 sales come from overseas. The world is very interconnected. Yes, capital flows will come to the country performing better than the rest. And I'm convinced our strong dollar, strong growth on a relative and absolute basis will attract capital investment.

But right now, the market is afraid that the weakness in Europe and China and so forth will spill into the United States, period. And then the Fed. The Fed's normalizing on top of that global fear produces uncertainty and from uncertainty, volatility. A recognition that the familiar Fed support of risk assets has taken off has become what it's become, a reality check, a volatile and uncertain market absorbing great U.S. corporate earnings, but in the context of global market weakness and monetary uncertainty. Well, what's going to end up happening? I think that the investors who will win out of this escapade, so to speak, who will do best, who will feel in the prominent position whenever markets resettle, will be those who have focused most on solid companies with less cyclicality in their earnings, more stability, more reliable cash flows, dividends in all market seasons. I think that behaviorally, those who stick to their investment disciplines maintain a key strategic asset allocation

that addresses their need for cash flow, their timeline, their risk and reward aspirations, their tax sensitivities, their tolerance for volatility, etc. Those who resist the fatal flaw of market timing, it's incomprehensible to me that one could believe they could trade this market right now and try to time in and out, moving up 400 one day and down 600 the next. And obviously, as I said, portfolios centered around quality, not momentum and hope. I need you to go to dividendcafe.com this week if you want to be able to see

a couple of different charts that I think illustrate some of the things taking place, the opportunity in the emerging market segment, I went through and posted every time that we've had a bear market in emerging markets going back almost 30 years, it's I think 11 different occasions, and what emerging markets had done one year later, what they had done two years later, you will see why we believe some of the opportunities coming together in emerging markets are so extremely opportunistic.

There's a rehash on some of the political things taking place right now, and then a chart that I can't possibly try to explain on a podcast as to why the overall systemic risk that is allegedly behind some of this that could go deeper, that would be more foundational, why we see that as actually relatively muted. But you'll have to see the chart of the two year swap spreads, which is both something you have to view to understand and something I have no intention of trying to explain because it is so exciting that I'm worried if you're driving right now,

you may get in a car accident. All right, I'm gonna leave you one little bullet point just for those of you that are somewhat political junkies and those of you that are market sensitive to these types of things. You can draw zero predictive value out of what I'm about to say, but certainly some anecdotal interest. I've shared it before,

but a statistical point as we go into the final week and a half before the midterms that my friend and mentor, Nick Murray shared with me, take a guess of the last year that of a midterm election that one year later the markets were down. Okay, well, we have a midterm election in this country every two years. The last time that after, excuse me, every four years, the last time that a midterm election one year later the market was down was 1944. Does this mean that I'm saying one year from after these midterms the market will be up? It does not. It means that the last time the markets are down one year after midterm was 1944. It means nothing more but also nothing less

than that. Something to think about. This is not a fun time in the markets, friends. I understand it, this volatility. I will share with you that intellectually, I am well aware of the fact that this is a good thing, and I'll explain in a second. But I'm also aware of the fact that emotionally, it's a very difficult thing.

People don't like this kind of volatility. And the fact that I'm aware that the risk premium we receive, that extra return you get for being an equity investor over time, comes from the fact that you have to endure periods like this. That is intellectually true and yet all the while emotionally unhelpful. Psychologically, these periods can be challenging. That's what we're here for. You have to reach out to us if you have questions on that, need to be guided through it, need to see what your specific portfolio strategy is. I also do not want to overdo it. This could get worse.

There's pretty much nothing that would really surprise me as to what could happen from here. I could see us dropping another 1,000 points, and I could see us rallying 1,000 or 2,000 points. A lot of this does feel to me like 1998. It's emerging markets driven. It's flat yield curve. It's questions about the Fed only instead of Greenspan. It's Powell. It's coming off of a big rally in markets. And then we had in 1998, what turned into a 20% drop. And then we rallied 20% into the final months of the year and the final couple, you know, let's call it seven weeks of the year and ended up up on the year dramatically. I'm not saying we're going to have a big rally at the end of the year, but my point is,

this is not a historical correction in the midst of a big bull market. But I don't know exactly how it plays out. I just know this, a defensively oriented, quality focused equity portfolio, well weighted to your own situation. It's the right thing to do. And messing around with it is not the right thing to do. Adding the bonds right now, you should have already, if you're a client of ours, the right allocation in your fixed income. Necessary to be defensive against equities, to hedge out deflationary risk. But we don't want to take excessive credit. And interest rate risk on the bond side means it's somewhat correlated with equities, not decorrelated.

onside means it's somewhat correlated with equity. It's not decorrelated. And that really drives us to heavier allocation in the alternative section, which is what we're doing and what we think we've done for a lot of clients and continuing to add now. So reach out if you have questions on any of those things. Listen to the Advice and Insights podcast for our commentary recap of the New York due diligence trip. Go to dividendcafe.com. If you, if you really want to look at the charts, get a little more reading around things. Most importantly,

reach out to the Bonson group. Anytime onward and forward. We go have a wonderful weekend and thank you for listening to the dividend cafe. Thank you for listening to the Dividend Cafe, financial food for thought. LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there's no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinion, news,

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