Don’t Be Fooled by High Growth Numbers
I know how depressed many of you are about this, but this will be the last edition of Dividend Café with the 2016 election results are unknown. There is no question that the picture for Presidential results is now highly up in the air, and any number of things could happen in the week ahead. By this time next week, the election will be behind us, and whatever that entails will be both known and priced. I am sure most of you are excited about this, as this election has exhausted many in the American public regardless of partisan leanings. Next week I will plan a special edition around the election and its implications for investors. In the meantime, we have a lot to cover this week so let’s get into it …
At first glance, I would like to take a second glance
The Q3 GDP number came out last Friday and reflected a headline annualized rate of 2.9% real GDP growth in Q3 (whereas Q2 was just 1.4% and Q1 was a pitiful 0.8%). We are on track to end 2016 at just 1.7% real economic growth on the year. However, the real story may be even worse. Exports were up 10% in the third quarter vs. the second quarter, a jaw-dropping number no one can really believe is sustainable (one report I read suggested that much of the jump was related to food exports around the weak soybean harvest in Argentina and Brazil). This was a meaningful contributor to the total number. And wouldn’t a stronger dollar (like we’ve had) dampen U.S. exports? Overall the number that has to improve to give us confidence in sustainable economic growth is fixed investment growth, and it just does not look positive yet.
Say what again?
I read a piece in the Wall Street Journal last week and have seen this mantra touted in various research pubs that we have been in a non-inflationary environment (true), and that high growth stocks have not done relatively well (untrue), while high dividend stocks relatively have (untrue until 2016), and that now if we do enter an inflationary environment it will be the more growthy, cyclical stocks that do well vs. the value/dividend names (painfully untrue). For those counting, that is a lot more “untrue” than “true.” The reality is that high valuation cyclical growth stocks up until 2016 were experiencing one of the most historically strong outperformance periods vs. value oriented names in history. We fully agree that the market has not priced in the idea of a deflationary paradigm becoming an inflationary one, but we vehemently protest the idea that cyclical high beta names are “now due.” The remedy in periods of inflation are (a) companies growing in excess of the rising inflation (so many cyclicals can do quite well here), and (b) companies growing cash flows and with that the dividends they pay shareholders (our sweet spot). The facts matter.
73% of companies that have reported Q3 earnings results have beaten expectations so far. 52% have beaten revenue expectations. Market stress in recent weeks is not related to Q3 earnings; it is despite Q3 earnings …
If not earnings, then what?
Market prices are, always and forever, a function of earnings… through time. Along the way, markets respond to noise, and right now there is understandably a lot of noise around the election. There are scenarios in the political realm that could create uncertainty, and until we are on the other end of that uncertainty, volatility will rule the day. Should the downside volatility elevate enough, we would have a chance to buy more equities at lower prices, but that has not happened yet. We would love to see it, but we can’t predict if it will.
A 70-year old Caucasian New Yorker is your President!
Of course, at press time, we do not know the gender or political party of the next President, but we do know (at this point) that the market will either be reacting to a Hillary Clinton or Donald Trump Presidency in just a few days. In the last week the polls have tightened a great deal, and current indications still suggest a modest edge to Hillary Clinton from an electoral map standpoint, but any realistic assessment suggests it is too close to call. Add in the possibility of a contested result in a state (or more than one state!), and you could have a really wild week next week. We expect there will be volatility in the week ahead in almost any scenario, as a “too close to call” outcome is the uncertainty markets hate most, a Trump win has largely not been digested by the market since his odds of winning have been so low throughout the campaign, and a Clinton win carries with it the questions of what the FBI investigations will bring. This political uncertainty is unavoidable right now, and yet I have a very high conviction that, regardless of specific outcome, it will prove to be advantageous to us through time.
Some worse news to supplement the bad news
Investors intrinsically worry about risk in the stock market, and a big part of that reason is that the risk premium embedded in stocks is largely due to the necessary volatility stock ownership entails. Our job is to exploit volatility, and to educate clients about its inevitability; not to time our way around it, or pretend it can be avoided. A common strategy for offsetting effects of equity volatility is combining stocks with bonds (a process called asset allocation) so as to create diversification of risks and rewards and economic sensitivities. One thing we are quite aware of (and have been for some time) which we think argues for greater use of non-correlated alternative assets for risk management is this: Bond yields are so low that many investors will be surprised at the negative price return they endure if and when interest rates rise. Put differently, their “risky” bucket might have some problems (say, in a recession or bear market), and their “safe” bucket might have much worse problems! Truly active and intentional management is needed in this day and age.
Hyper LOW Inflation, unless you are sick!
Here is a bit of a report card for the Affordable Care Act (ObamaCare) since its passage five years ago. The orange line at the bottom shows the very, very low inflation rate throughout the economy over that five years as the economy has muddled along (+6% cumulative). The light blue line showing the diagonal move up is the cost of deductibles for workers with single person health coverage (+63%). The +19% increase in premiums is one thing, and as the news has abundantly covered, the premium increase from 2016 to 2017 is the most significant yet. But the real story is that +63% jump in deductibles, because it has a profound impact on consumer spending habits.
Glass is half-full, or at least has an ice cube that will melt
I really do not want to be misunderstood this week. I am anticipating volatility around the election, and our chart of the week below provides some history that may be useful. And I do believe bonds that are sensitive to interest rate increases are generally over-priced, though I have believed that for many years now without much consequence. I do suspect selectivity will be an important part of stock performance in the next year or two, but that is not screaming bearishness by any means. And I do think a recession will come at some point in the next few years, but I believe it will be a mild recession by historical measures, and I believe it cannot be timed or forecasted. On top of all this, though, is my unwavering certainty that the profit motive lives on, and that no central banker or bureaucrat will ultimately stop the forward march of history, let alone the forward march of enterprise. Capital is inherently rational – meaning, it inherently seeks its most rational exploitation. Be a part of that; not a part of headline-driven investment policy.
Chart of the Week
The chart below shows the S&P 500 at the time of the last Presidential election (2012). Note how the market did going into the election, and then again the rebound that began about a week or so after the election. I circled the other spoke that took place in January 2013 because it was somewhat event-driven (prompted by Congress favorably resolving the Bush tax cuts). Past performance is certainly no assurance of any future outcome, but heavy volatility going into an election is the norm, not the exception.
Quote of the Week
“We forgive a child afraid of the dark; the real tragedy is when men are afraid of the light.”
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I mean what I say in this week’s edition that the outcome of the U.S. election really is in doubt. Not only is the outcome unknown, but when we may know the outcome is unknown as well (there is a possibility that come Tuesday night there will be inconclusive or disputed results in certain Senate races or even states that impact the Presidential conclusion). It strikes us as textbook foolishness to try and trade around such a thing. What we do know is that this long election cycle will soon be over – hopefully by Tuesday night – and that investors throughout this year, years past, and we are confident to say, years forward, who maintain a disciplined and consistent methodology will be the ones who achieve investment success. So to that end, we work.
Originally published on the Bahnsen Viewpoint.