Dollar Rally, Euro Drop, and Fear of Fed Tightening Explain Weekly Volatility
The ugliness of March continued largely led by a continued drop in the Euro. I explain more about this connection in this week’s commentary. All things considered it is a highly volatile time in the capital markets and I am not at all of the mindset that this is the end of it. But I also have a strong perspective to share and I think you will find the fundamental landscape along with monetary uncertainties along with investor behavioral responsibilities all juxtaposed in this week’s commentary. Let’s get into it…
My top points of the week, noted with an asterisk (*)
- Asset allocation trumps questions about the stock market one finds themselves in, though it behooves investors to have an intelligently constructed asset allocation
- This week’s market volatility was almost perfectly correlated with Euro weakness/dollar strength
- A long term strong dollar for the United States would be very bullish for United States investors. The question should not be, “What will we do if that happens?” but rather, “What will we do if it doesn’t?”
- Any expectation that oil price volatility is a thing of the past was and is misguided. There will be a catalyst to its turnaround before it turns around, and that catalyst has not yet surfaced
- Stock buybacks at all time high
When do you find the importance of asset allocation to be most elevated?
First of all, there is NEVER a time that I find the importance of asset allocation to be anything but elevated. With that said, six years in a row of a strong stock market is usually a pretty good time for people to start believing that they do not need any other asset classes besides stocks. In other words, it is times like this that asset allocation is most important. The merits of asset allocation lie in the reduction of dependence on one asset class and the reduction of volatility that this creates.
Are you bearish on stocks right now?
Yes and no. I am never, ever, ever bearish about a fully diversified growth-of-dividend stock portfolio with an adequate time horizon. In the very short term, though, I am quite convinced that we will continue to have spits and spats up and down and I question the investing public’s resilience to this benign volatility. We have had three moves up and down already this year of 3%, and some are acting like it is a bear market. How do I think the investing public would respond to an actually troubled market? The reality is that there is a lot of vulnerability in the market right now, which is probably why it should be bought, but with strong hands, not weak ones. Earnings may come in soft in Q2 (from Q1 results). I am glad right now to not believe in market timing, because it gives me one less thing to be wrong about.
How do you explain the volatility in the market last week?
A couple brutal days (Tue and Fri) and a huge up day (Thurs) – this is the volatility I think we must be used to short term in a market so heavily watching the Fed for its short term gyrations. This is different than if I were to say that the Fed’s decision to raise or not raise in June or September by 25 or 50 basis points actually mattered; I do not believe it matters – but I believe everyone guessing around it creates short term gyrations. Fundamentally, a sustained period of the Fed injecting liquidity into a market does push prices higher, and yes, a sustained period of a Fed extracting liquidity from a market pushes prices lower. But I hardly see the latter happening any time soon.
So this week’s volatility was about the Fed?
I suspect there have been no less than fifty times since 2008 when ZIRP began (zero interest rate policy) that SOME “fear” of a Fed growing a hawkish discernment surfaced and markets sold off, and in fifty out of those fifty times, the rally resumed when reality set in (they aren’t growing a hawkish discernment). What I mean by this is: The Fed is not looking to tighten yet or teach risk-takers a lesson. They have been hyper-accommodative and I see them being far more influenced by those begging that they not take the punch bowl away than the opposite. So between the dollar rally, the Euro drop (these two are one and the same), and the fear of Fed tightening, you have your weekly volatility explanation.
Are you worried about a stronger dollar?
I worry about not having a strong dollar.
Doesn’t a strong dollar hurt American companies?
Only if you think Zimbabwe is the strongest economy on the planet. Last I checked, a weak and collapsing currency is the sign of a disintegrating country. A strong currency is the sign of a strong county and strong economy. This whole conversation is economically polluted. I understand the downward pressure on profits it puts on exporters in the very short term, and I also understand that the same advantages and positives that created a stronger dollar environment more than compensate for this “fear” of a export disadvantage. Fundamentally, I have amp0le historical evidence to prove that a strong dollar, while subject to all sorts of random short term effects on the market, has co-existed with robust stock markets for decades (read: The 1980’s and 1990’s, for example).
More into the weeds, what caused the rally last Thursday?
I believe the release of the Federal Reserve’s bank stress test results was a big part of it. All U.S. banks passed the test, and 29 out of 31 banks had their capital plans approved which included a fair amount of stock buybacks and some dividend increases (still mostly very small). Most likely, though, the major story on Thursday was no different than the whole story of the week, which was the Euro/Dollar exchange rate. Each day the Euro dropped relative to the dollar the stock market fell; the one day the Euro moved up vs. the dollar (Thursday), the market rallied (meaningfully). There is a strong correlation at the moment between the S&P 500 and the Euro currency.
What do you propose we do about that?
I don’t propose we do anything about that. Fundamentally, I do not believe a LONG TERM strong dollar is anything but a GOOD thing. Shorter term, I don’t believe ANYONE can trade around USD/Euro exchange rates. And as for finding out how to trade equities around how to trade the foreign exchange? No, I have no proposed action. What I do propose is this: Buy companies which you believe can sustain a growing dividend in all sorts of climates so that when we have seasons of a dollar rally, or a dollar drop, or a this kind of zig or a that kind of zag, you can know that your investment needs are well met.
But surely you believe there are such things as actionable events in the market?
Most certainly I do! And we can spend time walking through examples of things that fall into this category, but short term currency movements potentially affecting short term earnings per share is simply not one of them. I am saying both that it cannot be done, and that it should not be done. That distinction is important.
Was a lot of the market’s drop last week connected to the drop in oil prices?
Yes and no. I do not believe the market dropped because oil prices did and I do not believe oil prices dropped because the market did, but I do believe that macro factors were at play in BOTH drops (mostly related to U.S. dollar strength). More significantly on the oil side, The Energy Information Administration (EIA) released their Drilling Productivity Report showing more production projected in most key U.S. basins for April than has even taken place in March and February, meaning that the much talked about collapse of production in response to the collapse of price has not exactly happened. Supply and Demand being what they are, projections of increased production mean more supply which means more downward pressure on prices. The spread between Brent and WTI has remained high which has been very good for the refiners. I am watching crude inventories to keep an eye on that spread which has no impact on my pipeline investments but does on the refinery investments.
Tough week for the pipelines?
In price and sentiment, yes; in fundamentals, no. The consistency of dividend growth across this first quarter has been something to behold. When one looks at the MLP sector they need to look at the specifically MIDSTREAM part of the MLP space to understand where we are invested at The Bahnsen Group. In that space, we continue to experience distribution expansion and volume strength. I have seen the space bounce around a bit in terms of pricing this year and this week was to the downside, but I place absolutely no timeline on a “new high” in price. Whether we are compounding our dividends or spending them the mark-to-market price value here is truly immaterial, and if we are compounding, the lower the price, the better.
Your international note of the week?
I continue to enjoy my weekly reading on India as much as any reading I do. Their rather problematic inflation level has seen significant improvement in recent quarters, led by both improved currency dynamics and lower oil prices. Local growth has been strong. Current account deficits have decreased. Fiscal deficits have decreased. Indian stocks were up huge last year, so I am more talking about the economic story than the stock market story, but as a bottom up guy who does believe there are a lot of great growth companies in the country of India, it is very helpful to see a healthy macro country environment around what we are doing. A reduction in the corporate tax rate is likely coming, and the new prime minister has laid out a solidly pro-growth budget. Keep watching this story, but know that our exposure will only be on company by company basis within our emerging markets strategy.
This week’s reminder to coincide the market bottom of March 2009:
I already wrote a few weeks ago about the behavioral lessons embedded in the market collapse of 2008/2009 and the recovery we currently find ourselves living in. That point is not so much an ad hoc point I made a few weeks ago, as much as a permanent truism I try to write about every week: Our results will almost entirely reflect the wisdom of the mistakes that we do not make along the way. Changing gears from the historical example of this great point – that being the market recovery since March of 2009 – I want to refresh some memories since we have spent so much time talking about “dollar strength” this week. The predominant theme in the press this whole week has been “what to do about this super strong U.S. dollar”. I have gotten a fair amount (not an avalanche) of emails from people wondering what our strategy is for the strengthening U.S. dollar. But here is the thing … It is hardly ancient history (2009, 2010, 2011, 2012) that I was FLOODED, and I mean FLOODED, with emails from people wondering what we were going to do about the DYING U.S. dollar. People were not worried that we were turning into Switzerland; they were worried we were turning into a third world currency. I saved every single one of these emails. I watched pundits on talk news shows. I archived newsletters. The great theme just a few USC football seasons ago was “the great pending dollar collapse”. And now people just state it matter of factly that, “oh we have big problems with this strengthening U.S. dollar”. Forecasting the direction correctly is not the need of the hour. An appreciation for journalism’s apocalypse du jour is needed, but so is a governor on that most malignant of investor results: Our own behavior. Avoid the hype. Avoid the panic. Seek wisdom, and with wisdom, truth. That is what I am here to give you: the truth.
Well what is the truth about why the U.S. dollar didn’t collapse? It seemed like they were printing trillions of dollars a few years ago?
A huge part of the problem then was a classic ignorance about what a “weak dollar” is … Currencies only go up and down AGAINST EACH OTHER. It is a value of EXCHANGE. In other words, it is a relative game. Dollar bears failed to appreciate the global realities that would push Yen and Euro down, and they continue to miss this today.
The announcement that a company is “buying back” its own stock (therefore reducing total number of shares, which increases earnings per share). Generally considered to be a bullish sign and positive use of company cash. The all-time monthly high for corporate stock buybacks was July 2006 (until February 2015, that is).
QUOTE OF THE WEEK
“The exact contrary of what is generally believed is often the truth.”
— Jean De La Bruyere