What to Worry About is Different Than You Think
Dear Valued Clients and Friends,
Markets enjoyed some more upside this week and are tying or setting various records here and there and everywhere. It provokes conversation, risks complacency, and most importantly, creates the need for behavioral counseling from top-shelf wealth management practitioners. Some of the brightest people I have ever met are highly prone to incredibly destructive behavioral decisions in the investment world. So we work … Enjoy this week’s Dividend Café.
Intelligent caution needs an intelligent basis
For all the things we want to accomplish with Dividend Cafe, the number one priority has always been “giving our clients a look at what is in our minds week by week.” To that end, it needs to be said that high yield bond spreads at 380 basis points is taking up more mental shelf space for yours truly than anything else right now, much more than the price level of the Dow. What this means is simpler than the jargon sounds: The average “spread” or “pick up in yield” one gets from buying Treasury bonds (guaranteed by the United States government) and a basket/average of very credit-risky corporate bonds, is 3.8%. This is not the insanely low spread of 2.5% we saw in 2007, but it sure isn’t the 8% spread we saw a year ago, or the 5% spread we generally average. It implies a very low fear of risk from investors around risky credit. It can be a very positive thing, but it also risks serving as a sign that investors are too darn complacent about risk. I understand the pedestrian and even somewhat justifiable (prima facie) fear an investor may have when the Dow hits new levels (“geez, are we getting too high in stocks?”) – fair enough. But there a million things that can be said there. Excessively tight high yield bond spreads, though, are hard to justify for any extended period of time, due to the very nature of business cycles and risk/reward. We are watching, we are thinking, we are NOT complacent.
Asset Allocation doesn’t neutralize courage; it mitigates risk
One of the most painful things for an asset allocator to do is pull the trigger on a significant, systemic, significant change in the big-picture paradigm that has been driving asset allocation decisions for a particular period of time. Trimming equities from 58% to 55% for a given may or may not be the right thing to do at a given point in time, but it is hardly the stuff paradigm shifts are made of. However, determining that the significant global condition (deflationary pressures) is being all together replaced (say, with inflationary forces) would be a bold and challenging step to take. We have been carefully mitigating global deflation risk for eight years now, and we think we have done so wisely, effectively, and prudently. The question in front of asset allocators right now is whether or not the forces of the last eight years (global deflation risk) are now obsolete, with there being upside risk for exploding nominal growth. Several analysts I respect are predicting just this. It is certainly true that global yield curves have steepened (spreads between short term and long term rates have expanded), even as all
points on the yield curve are relatively low compared to historical levels. This does imply higher nominal growth. So why are we not going beyond “tweaking” of asset allocation levels, and going all-in for cyclical stocks, commodities, and other reflationary beneficiaries in the capital markets of risk? In a sense, we have done just that. Our bond portfolio is very short duration, and very focused on credit risk (bank loans, high yield). And our overweight in emerging markets is a solid belief in rapidly expanding nominal growth (globally). However, we have made the decision to use real life companies as a medium for reflationary exposure, not direct commodity investments. This is a simple belief about risk and reward. And the quality of stocks we own has never been an expression of a particular cycle’s outlook, but rather the permanent bias we have for growing cash flows. Are there periods where risk gets re-defined, and one portfolio may stutter while circumstances around it re-calibrate? You bet. But our belief in how to best combat deflationary and inflationary forces is not at all cyclical. We have plenty of courage driving our asset allocation decisions, but they are never devoid or prudent risk assessment.
Things seemed expensive, so I gave my wife the credit card anyways?
It is pretty rare in the Dividend Café that I quote from other materials which serve as resources to our process, but every now and then something is so intelligently-worded that I feel compelled. The word “overbought” is thrown around a lot in our business, and there is a logical inference at play that if something is “expensive,” it is about to go down in price. I quote verbatim here from Charles Bilello.
One cannot predict another bear market based on extreme overbought levels alone. Bear markets can happen at any time, and “overbought” is neither a predictor nor a precondition. If one is going to predict anything based on extreme overbought levels (and I would advise against doing so), it would be further gains. I realize that doesn’t conform to the prevailing narrative of “overbought is always bearish,” but the truth in markets rarely does.
– Charles Bilello, Feb. 17, 2017
Do we want to load up on assets that we think are “overbought” (or “expensive)? Of course not. But does history teach that us that convictions based purely around timing do not end well. Markets confound investors all the time; they do damage to disciplined asset allocators far less.
It already went up, or did it?
One of the arguments we would make for the embedded value in the energy sector is that the equities in the space have not participated yet in the movement of oil prices themselves (the lag effect). Though our preference is on particular operators and companies that meet our specific investment criteria, note the difference between oil prices themselves and the energy sector index since the election.
Don’t tell Reno, Nevada it’s been a warm winter, but natural gas prices tell it all
There have been pockets of the country that have had incredible snow and extended cold season throughout the winter, but those pockets are few and far between, and the northeast is definitely part of it. It has actually been a very warm winter across the country (on average), and the result has been a cratering of natural gas prices despite the big moves up in most commodity prices.
Originally published on Dividend Café.