A Gold Medal for Disciplined Investing
Dear Valued Clients and Friends,
We entered the month of August having enjoyed a great year so far in our equity and fixed income results, mixed results across various alternatives, and a lot of unknowns in big-picture macro affairs. No honest (and appropriately humble) portfolio manager should fail to recognize right now that there is risk in both directions for markets. (If one reduces equity exposure in a meaningful way, and then better economic news than anticipated comes or global affairs turn unexpectedly and stock markets rally hard, that can be just as frustrating as when one increases equity exposure and a sell-off ensues.) Risks feel heavier on the downside, though, and we also have to constantly remind clients how dangerous it can be to obsess over weekly or monthly movements. We discuss all of this and more this week, so let’s get into it…
Watch this Video Executive Summary at this link.
- Oil has resumed a downward trend breaking modestly below $40 and re-igniting concerns about global strength. (Though it bounced higher Wednesday and Thursday.) Equities had not been participating in this downward move, actually going the other way throughout most of July. Stocks saw a lengthy losing streak recently, although it was mostly a combination of very light down days. It was surely correlated with the drop in oil to some degree, though, so far, besides some weakness in energy stocks, it hasn’t really caught up with the Industrials and Materials sector.
- Investors deserve an absolute result – an investment strategy tailored to them achieving their goals – not a random, arbitrary, and irrelevant focus on how they did relative to the stock market. Investors have different goals, different risk profiles, different timelines, and therefore, different asset allocations. To try and “benchmark” to the S&P 500 is not just unhelpful, it is dishonest. More on this in the first section of the below Q&A.
- The economy may go into a recession next year (it may not), and stocks may go down next year (they may not). Portfolio decisions need to be made around liquidity needs, liquidity protection, and, of course, valuations. The income a portfolio generates needs to be growing whether its value is growing or not in a given period. Short-term excessive timing decisions are not only a gift to the tax man, they are utterly futile for one’s investment return.
In the News Last Week
- The Trump campaign is in total disarray. Hillary Clinton’s lead in the polls is now astronomical.
- The Bank of England cut their federal funds rate by a quarter of a point as expected, their first rate cut since March 2009.
- We went to press just before the jobs report Friday morning came out so, by the time you are reading this, the July jobs report has been released, but we will cover its implications in next week’s Dividend Café.
- China – Nothing of note to report for last week.
- Oil – It broke below $40 and is showing a technical deterioration that could bring it to the mid-30′s. Talk of extra production in Iran, Iraq, and Libya are affecting supply concerns, and the dollar is sort of all over the map as it is doing different things in relation to different currencies.
- Recession – Q2 real GDP growth came in at a +1.2% annualized level, with only the consumer holding things together. Fixed Investment, Inventories, and Government spending all subtracted from the economy in Q2. The bottom line is that an inability to get to 2% real GDP growth, let alone 2.5%, means that the economy does not have the cushion to withstand the negative drag of global slowdown in to the next 12, 18, or 24 months. CEO confidence and Fixed Investment are the two areas that would have to move:
- Earnings – It is interesting that for all of the very logical concerns about earnings growth deceleration, there has been almost no talk about top-line revenues actually growing year-over-year in Q2 (the first time this has happened since Q2 of 2014). 71% of companies have beat their earnings estimates and 55% have beat their revenue/sales projections.
- Election – The post-Democratic convention bounce was as big as expected. Most national polls now show Hillary Clinton in a firm lead over rival candidate, Donald Trump. There is a lot of chatter of disarray in the Trump campaign. I want to see more data from my market resources, but, at this point, it does seem that markets are firmly pricing in a Hillary Clinton victory.
Questions from Readers
- Could you include market indices in this Dividend Café commentary that compares what your portfolios have done to the market over 3, 5, 10 year windows, and also tracks it quarter by quarter?
No, we could not, and we would not, but it would be good to explain why: a) We only manage money on a custom and discretionary basis. How could we compare “our portfolio” to a market index when various clients have dozens of combinations of portfolio compositions? b) What market index would we use? Some clients have emerging markets; some do not. Some have 30% stocks; some have 70%. Some use taxable bonds; some tax-free. The S&P 500 is 100% U.S. equity. So it doesn’t work unless we want to compare apples to oranges. A custom benchmark could be created for one client, but the allocation of that client changes over time, and the custom benchmark for one client surely wouldn’t apply to another. And then there’s, by far, the most important reason: c) If we did such a thing, we would basically be implying something that is utterly false – and that is that comparing one’s portfolio to a “market index” has any benefit, meaning, or utility whatsoever. It is the height of dishonesty to even play into the farce that such a thing means anything to our clients, let alone to us. We manage money, to the best of our ability, to see the cash flow our portfolios create grow year over year, either for someone withdrawing it, or someone reinvesting it. If in a given year our raindrop is moving down a window faster than the S&P 500, it creates no cause for celebration. And if one year it is the market outpacing, it certainly causes no distress. Our clients hire us to create a certain result in line with their goals and needs, and to do so within their comfortable level of volatility. That’s our benchmark. That’s our index. No one, and I mean no one, has a “goal” of beating the S&P 500. I ask people all the time, if you had been up 1% per year from 2000-2009, would you have been happy? They always say, “of course not.” But the S&P was totally flat in that period, so 1% would have “outperformed.” Would someone have cared that they beat the market by 8% in 2008 if they were down over 30%? Our “index” is to create a valuable flow of income and a valuable growth of that income, and, in doing so, create a consistent return with much less volatility. That’s what we do, and we are focused on it.
- So is the driver for Emerging Market stocks now just the expectation that weaker monetary policy will continue in the United States and elsewhere keeping the dollar down and EM up?
We actually talk in the “bull in us” section this week about why we are optimistic about emerging markets bonds, but we want to reiterate that with emerging markets stocks, we are not looking to invest in a short-lived, monetary-driven rally, but rather in operating companies with real earnings, real earnings power, and a real long-term growth story that transcends the extremely transitory nature of things like currency movements. So for us, we: a) respect that the monetary policy happenings around the globe will create short-term impact on our Emerging Markets investments in both directions; and, b) desire to be invested in Emerging Markets companies that have long-term, fundamental attraction.
- If you believe stocks will drop 50% next year, should I go to cash next year since I need income from my funds in the next few years?
We have said we see a 40-50% chance of recession next year, not a 40-50% drop in stocks. As one getting closer to needing funds, your financial advisors (us) need to plan your liquidity needs well enough so that what you need is always there when you need it. As one who will need funds, with cash and bonds paying close to 0%, the reality is that cash and bonds could become a bigger risk to your goals. Market timing is a fool’s errand. It doesn’t work. We manage the risk, watch valuations, and above all else, intelligently plan for liquidity needs.
- What is your take on the state of MLPs into this magnificent rebound?
MLPs, otherwise thought of as oil and gas pipeline companies, have indeed seen a rebound since February of this year. 30 out of 79 companies which have announced their Q2 results have actually risen their dividend quarter-over-quarter. Many have held them flat. Only two have seen a cut. Despite our optimism for the vast majority of the space, we are choosing to focus our exposure to quality terrain in the oil/gas pipeline universe for substantial risk-adjusted results.
- With how weak growth is everywhere else and how the U.S. economy keeps “chugging along,” why is the dollar going down a bit against other currencies?
I think the dollar weakness despite the U.S. economy “chugging along” is all about monetary expectations. The pitiful 1.2% real GDP growth of Q2 at first read may be stronger than elsewhere, but the weakness of “elsewhere” was baked in. What pushed the dollar down was that the weakness was adequate to reinforce to traders that the biggest catalyst to dollar strength (a tighter Fed) is off the table, yet again.
Deep End of the Pool
There is a question this week about what to do if we enter recession next year, and there is a lot of discussion above (and some charts) about the pitiful 1.2% annualized real GDP growth we saw in Q2. The reality is that it is government as a size of GDP that has exploded, and therefore crowded out private investment, leading to this muddled economic growth.
Weekly Reinforcement of a Permanent Principle
Risk is the possibility of permanently losing money. Volatility is the expected fluctuation in value as we advance towards our goals.
Comments from the Bull in Us (What We Like)
One of the most interesting things to happen in the last few months, and one of the most rarely discussed investment strategies, ever, is the move in Emerging Markets bonds. We talk about the equity of the Emerging Markets all the time, but we do not talk about the debt often enough. (And we talk all the time!) The good news is that the asset class (which we got out of in advance of the sell-off the space saw in 2014 and 2015, but have opportunistically re-entered in 2016) is now benefitting from huge inflows of capital (+$1.4 billion last week alone; a second record week in a row). The bad news is that the reason for it is investors searching for yield in light of the negative yields they see in other parts of the globe. So, on one hand, we like the story here, but, on the other hand, we do know a risk build-up is likely.
Comments from the Bear in Us (What We Don’t Like)
We have said for quite some time that we believed the incredible incentives the auto dealers were offering in 2013-2015 were really just pulling future sales into the present, and would catch up with the industry later. It looks like we were right.
Switching Gears (Outside the World of Investments)
If you are looking for assistance in your own bookkeeping and financial record-keeping, please let us know. We have a handful of options that may be very good fits for your personal or business needs.
And if you run a business with a 401(k) plan, we are hosting a really value-added breakfast event on August 30. See the details at this link.
Chart of the Week
A lot of you are, of course, not from California, but I have found that Californians are always interested in learning about their state’s fiscal status, and non-Californians tend to almost take glee in seeing California’s woeful management. This chart seems to say a lot.
Quote of the Week
“Destiny is not a matter of chance; it is a matter of choice. It is not a thing to be waited for, it is the thing to be achieved.”
~William Jennings Bryant
* * *
The run in markets post-Brexit, particularly in the types of bond sectors we are invested in and then also the dividend-rich, low-volatility spaces we tend to like, has been extraordinary. The prolonged period of “everything going well” is never something we like to see (though we understand why clients do), because it creates the inescapable feeling of, “okay, what’s about to happen?” Markets are looking for various ways to normalize, to break apart certain correlations, to let some steam out, etc. The volatility has been very low the last few weeks, but it hasn’t yet turned into a “calm before the storm” moment. People will often ask, “What are you planning to do next?” The truth is that sometimes the best next step is to do nothing. We have well-balanced client allocations, a small tilt towards the more conservative side, and most importantly – we believe we have our clients well bought into the pivotal investment wisdom dictum that short-term movements are both completely unpredictable and completely irrelevant. We are playing more defense than offense, and are heavily engaged in the macro picture. But as any chef knows, if you just start throwing in more seasoning for the sake of doing such, and keep stirring the pot for no good reason, you risk messing up what was already a pretty good dish. We believe our portfolio process is appropriately elegant but simple, thoughtful but not excessive, and intentional but not stubborn. So, to that end, we work.
Originally posted on Hightower Advisors.
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