Learnings, Earnings, and Yearnings
There are a lot of charts this week and various illustrations that I think will make this a really read-able and really informative edition of Dividend Café. We want to share with you some of the things we have been learning lately in various studies, take a look at early earnings results and what it means for the markets, and digest it all for what investors are most “yearning” for. Hey, sometimes we have to stretch if we want to keep a clever, rhyming title. This is actually one of my favorite Dividend Café editions in quite some time (we’ll see if you can guess why). With all that said, let’s get into it…
Early indicators are a surprise to all who are often surprised
Only 90 or so companies in the S&P 500 have released Q3 results thus far, but so far Financials and Materials are leading the way, two very maligned sectors who were expected to perform abysmally. The surprise here is in those who were not expecting this, as sectors baking in bad news and then outperforming the lower expectations is as predictable as the very concept of earnings surprises.
Remember that supply glut?
I read a fascinating report this week suggesting that oil shortages will be the story of 2019-2020, not excess supply, as the massive efforts to cap production in the wake of the oil price collapse of 2014-2016 will suffer a lag effect, and end up leading to a production process unable to meet demand needs within a few years. The Saudi energy minister said this week at the World Energy Congress that over $1 trillion of oil projects have been cancelled or delayed since the price drop worldwide. And production capacity can not be turned on and off like a light bulb – a field producing oil in 2020 likely meant the wheels were put in motion in 2016 or so. Shale, of course, is still the wild card, and how America decides to assert its energy independence will matter a great deal.
It’s the cash flow, stupid
I actually teach my kids not to say “stupid,” but it is election season, and James Carville’s famous dictum from 1992 (“it’s the economy, stupid”) was meant to be a generational reminder to politicians always and forever that people vote their pocketbooks. I want investors to always and forever remember that what drives markets is earnings, and we care about earnings to the extent they drive a return of cash to shareholders. This chart tells us all we need to know about the post-crisis rally for the ages in stock prices. Have low interest rates helped feed growth, and helped feed affordability of stock buybacks plus dividend growth? Sure. But fundamentally, as dividend growth and return-of-cash goes, so goes stock prices. Earnings are the mother’s milk.
Be careful what you DON’T wish for
There is more effort in my business to “control” volatility than almost anything else, and very seldom to we hear from clients that they are afraid of actual loss – when we dive deep enough we almost always find that client concerns are actually temporary volatility. And human psychology and emotion are reasonably immutable, so we get it. But take a look at the chart below from our friends at First Trust. Intra-year volatility is a given – an inevitable part of investing – the rule, not the exception – and the results to those who have allocated well and maintained a defensible and disciplined strategy through the thick and thin of volatility have been stellar.
Bottom line – stocks have been up in 77% of the last roughly 100 years, and down 23% of those years. And in the down years, the AVERAGE down year is roughly 14%. That volatility has been the price an equity investor has paid for equity like returns. Intra-year volatility is even more benign. To compress the volatility is to compress the return premium. You get my point…
But lest we forget …
And by the way, this same “volatility” is not something stock investors take on but bond investors get to skip. The ten year bond yield was 15% in 1981 (35 years ago), and it is just over 1.5% now (a bond bull market for the ages – a 35-year period of interest rates dropping 90%). However, even in the midst of a 35-year move down for bond yields, in 13 of those years (fully 1/3rd) the yield was higher year-over-year (meaning bond prices were lower). So you had to have a negative return more often in bonds than stocks over this generation, and yet you took on that greater negative volatility for the return target of bonds, not stocks. What is sauce for stocks is, um, sauce for bonds too?
You haven’t gone crazy. People do indeed borrow more when it cost less
One of the most questionable assertions many have made in the last few years is that a low cost of money does not necessarily correlate to higher borrowing. It is not only a bit silly intuitively, but empirically as well. Notice in the chart below how the lower interest rates at which debt was available translated into an increase in total debt levels (even as the expense of the interest did not grow so dramatically). There is room for debate over whether or not this is a healthy development, but there is not room as to whether or not it has actually happened. Debt levels are higher, and with it (to a modest degree) the money being spent on interest expense.
When being uncool is more profitable than being cool
One of our themes entering 2016 was “old tech” names (where there was price value and dividend growth) being the better play than “new tech” where, despite the “hipness” of the names, high valuations had run amok. Note the 2016 chart below demonstrating how this has played out so far:
Digging deep for a second
I’ve already tried to be sensitive to those who have asked that I make the Dividend Café writings more “readable” and clear, and this week’s in particular happens to have a lot of charts and such making various points which I suspect helps the overall clarity of the message. But I would be remiss if I didn’t make this next point despite the obvious complexity of it all. The story of 2016 in financial markets is likely something none of you go to bed thinking about, and it is the Yen’s 14% RISE against the dollar. Of course we talk about bond yields and such too, and those things all play directly into things like foreign currency exchange, but fundamentally, you have an economic giant (Japan) doing everything under the sun to weaken their currency (so as to export their deflation) – from printing trillions of Yen to implementing unprecedented negative rates to going so far as to buy stocks with central bank money – and yet they have seen their currency rise 14% against the dollar. This is a major financial story because it (a) Shows the complete impotence of central banks right now even when they use their biggest guns, and (b) It defies the economic logic that drives mainstream thinking (Japanese stocks zigged when experts said they would zag and then they zagged when investors were sure they would zig). Japan is a case study for what not to do in so many ways, here we are, watching policymakers around the world follow suit. It is surreal.
So if it’s not door A, is it door B?
When I say that monetary authorities are largely out of bullets to effectuate economic activity and progress, does that mean I am advocating for fiscal activity to spur growth (i.e. Keynesian government spending)? What we know is this: government spending increased 4.6% per year for 25 years going into the 2008 crisis, and coming out of the crisis the Keynesian remedy was a stunning 23% increase in government outlays. The results are well-known: GDP growth has been well less than 2% for years and years now. Whatever growth that government spending created was front-loaded and simply pulled into the present growth from the future. Worse, it crowded out private market activity which impeded overall organic growth all the more. And of course, it added untold trillions to the national debt. So am saying door A (monetary manipulation) and door B (Keynesian stimulus) are both busts? You bet I am. If only we had a model for real organic, dynamic growth (such as JFK and Reagan supply side tax cuts?).
The case for re-thinking the very act of thinking
Where hedge funds and alternative investments have failed to add alpha into a portfolio return over a sustained or legitimate period of time, they have failed in their role as a portfolio inclusion. By “alpha,” we mean an investment return in excess of what normal asset class returns could be, adjusted for the beta (the market risk/correlation). It behooves portfolio managers like us to incorporate alternatives where beta will be very, very low (so as to maximize their benefits as diversifiers). From there, manager skill needs to create the excess returns, at least through time. Hedge funds have had a tough go of things in the last year (at least many of them have, certainly not all), but any further look shows that as the timeline is expanded, the excess returns (alpha) and the diversifying benefits (non-correlation) grow. Fees are often blamed for hedge fund problems, but of course fees are lower now than ever, and hedge fund outperformance was highest in the period when fees were highest. Ultimately the answer is in these two realities: (1) When Beta is doing just fine (standard broad market exposures), no one feels they need non-correlation, so the thesis for hedge funds gets undermined. And yet the very point of alternative investing is for when markets are not doing all the heavy lifting themselves; (2) Not all hedgies are created equal – there are different managers and different strategies executing different viewpoints in different asset classes at different points in time. Broad brush painting doesn’t work here.
Chart of the Week
The chart below shows the expectations for earnings growth going into each of the last dozen quarters, and the blue bar represents the actual results. As you can see, earnings growth exceeded expectations each and every quarter, even when expectations for growth were negative. We have had five consecutive quarters of earnings growth being negative, and Q3 2016 may very well end up being the quarter that bucks that trend (we shall see).
Quote of the Week
“However beautiful the strategy, you should occasionally look at the results.”
– Sir Winston Churchill
Originally published on The Bahnsehn Viewpoint.