A Quarter of Optimism
And just like that the first quarter of 2017 is behind us. You may feel like it seems a year has gone by since USC’s glorious win at the Rose Bowl, or it may seem like the inauguration was just yesterday, or, if you are like me, a case can be made for both. Regardless of how 2017 feels to you, we are off and running, and have a lot to say this week about where things stand and what we expect. So with all that said, let’s get into it …
Trumpian down days or business as usual?
Markets have absolutely priced in a good portion of the anticipated “Trump stimulus” – primarily, the expectation of corporate tax reform and foreign profits repatriation. Should these policy expectations come under jeopardy, we are quite certain the market would react negatively. The recent downside volatility reflects SOME reality around the failure of ObamaCare repeal – the market still believes tax reform will get done, but no longer sees it as the easy ride they thought it would be. From a risk/reward standpoint, last week’s events just boost the risk premium. Where market valuation comes in is that markets are priced to where there is little margin for error. Now, the number of consecutive down days is pretty misleading, because the aggregate drop from peak to trough is still quite insignificant, and markets remain up over 4% since 2017 began. But ultimately we are a couple weeks away from Q1 earnings season starting (the next real catalyst), and market actors are wisely afraid to bail completely (as the risk/reward skew is still towards tax reform happening), yet a little gun shy and timid given the debacle of last week.
The path to tax reform
More or less, what most market actors are looking to in the aftermath of this ObamaCare situation and in evaluating the political lay of the land is what the outlook is on tax reform. The market is looking for significant relief to corporate tax liability, and in fact has largely priced that in. We don’t use Dividend Café to give political advice, and no one would be listening if we did. But predictively, we imagine there is likely to be a political realization that a quick and easy corporate tax cut, separated from more comprehensive tax reform, may be an easier way to go. Investors need to remember that passing something through budget reconciliation requires just 51 votes, but a full legislative change will require 60 Senate votes to overcome a filibuster. The Border Adjustment Tax appears dead on arrival, though even that could change if President Trump were to aggressively try to sell it to the American people (I personally am skeptical that he will go that path). Ultimately, there is skittishness around how this will all get done, and our own forecasts are fluid because circumstances are fluid; but yes, we believe there will be corporate tax reform as the market desires, even if it is done piecemeal (from more comprehensive reform). We further believe it is repatriation of profits that is not totally priced into market expectations!
Is the glass half-long, or half-weak?
There is no shortage of dialogue about how long this economic recovery has been – which is true enough … But we might gently suggest that the far more important consideration is how weak it has been, not how long it has been. The very low and slow nature of the growth distorts the length of time it has been taking place, and makes historical analogies impossible.
If only there were a clue available
Financial stocks, the leading beneficiary of the Trump Bump since November, have declined modestly in recent weeks, causing some to wonder if the hope of regulatory relief coming has been derailed? In fact, the explanation is no more likely than the chart here indicates: As treasury yields go, so go financial stocks. In this sense, it is wise to think of many of your bonds (treasuries, municipals) as inversely correlated to financial stocks.
On March 21 the Dow Jones lost a tad over 1% of its value. On March 28 the Dow gained very close to 1%. The March 21 down day marked the longest streak without a 1% down day for the S&P 500 since 1995 (22 years). The period we have been in of nearly non-existent volatility is not the norm; 1% up and down days happen. In fact, they generally happen quite a bit. We, in fact, have averaged about 60 trading days per year for nearly one hundred years with 1%+ up or down days (one out of every four days). So sometimes they happen a LOT (2008, anyone?); and sometimes they happen rarely (the last six months). Volatility is always and forever mean-reverting, just like returns are, so to the extent that we have had below-average volatility for some time, our advice is to prepare for greater volatility in the future, even if we cannot time exactly when that may be.
Beyond volatility, let’s talk real pain
No one troubled by a 1% down day in stocks should be invested in stocks, for rather obvious reasons. But volatility of 1% is benign. What about real down periods? For nearly one hundred years, there have been, on average, over three periods PER YEAR of a FIVE PERCENT correction (or more). Again, THAT is the norm … Investors accumulating capital and net worth should welcome these routine corrections (reinvested dividends at lower prices not to mention new contributions to a portfolio benefit immensely from low prices). And investors withdrawing from their portfolio who utilize a dividend orientation immunize themselves from price fluctuation because their withdrawals come from what can go never go negative – positive dividend cash flow!
We look at some of the companies we own and have recently bought in the U.S. energy sector, and get very excited. We see an energy sector coming off an unprecedented period of five year under-performance to the broad S&P 500. We see a sector nowhere near it’s all-time high. We also have written time and time again about the policy paradigm, and not just in terms of deregulation, but also President Trump’s obsession with narrowing the trade deficit. Natural gas exports are a no-brainer part of increasing U.S. exports, not to mention creating new jobs. We see electric vehicles gaining more traction, driving natural gas demand higher (as natty gas, not coal, more and more powers that electricity). So we see a paradigm that meets what so many people are asking us for – investment opportunity lined up with where the Trump administration is, that is not way ahead of itself in terms of prices or valuations.
What if Trumpflation is dead?
The market rally since November has largely been based on expectations of nominal growth to the U.S. economy centered around favorable growth policies from the Trump administration and other cyclical realities pointing to a stronger and growing economy. But what if those things flat out fail to materialize? Well, for an asset allocator, bond yields would drop, boosting the bond prices of their portfolio. And emerging markets would likely rally, as growth there is far less expensive and the fear of a headwind from the dollar would decrease. The point we are making? No portfolio should be entirely levered to just one perspective or thesis within the economy. These things are dynamic, and require dynamic investment allocation.
When growing income meets growing value
It is, of course, a cornerstone of The Bahnsen Group’s investment philosophy that assets which are growing the cash flows they pay out inevitably see their values grow too, though we are agnostic about how this process plays out in a given month, quarter, or even year. What we feel has plenty of empirical support, though, as the historical reality that dividend growers trump mere dividend payers, let alone non-payers and cutters.
Indexing and the last 17 years
We hear all the time how so many active managers fail to outperform the S&P 500, and of course, we hear it because it is true. Particularly in bull markets when a rising tide is lifting all boats, the S&P 500 has traditionally generated a return that a lot of managers have not beaten. Of course, that tends to miss the point dramatically. The asset allocation most appropriate for a given investor is not resolved in buying the S&P 500. The emotional temperament issues that give way to behavioral mistakes is not addressed when one talks about a straight S&P 500 investment. But putting all that aside, do you know what the return is of the S&P 500 since this new millennium/century began? After all, we are up over 250% in the last eight years alone as you may recall. Well, for 17 whopping years, going back to the turn of this new and so
far unsettling century, the S&P is up just 4.48% per year, and to achieve that, it has taken on a whopping 17.76 standard deviation (let’s just simplify by saying – that is a LOT of volatility and risk – a LOT). So is the question facing investors “to index or not index”? Not if the last 17 years mean anything. The question is, “what kind of planning, asset allocation, monitoring, and mistake-avoidance is needed to properly compound my capital through a very complex and challenging period of economic history.” So to those ends, we work.
But are the big boys throwing in the towel?
The largest creator, distributor, and manufacturer, and marketer of index-based exchange traded funds (ETF’s) – generally passive vehicles that track a particular market index – announced this week that they were shedding more and more of the resources in their active management division. What does this say about the viability of active management? Our own Robert Graham, Private Wealth Advisor and Executive Director of Corporate Retirement Plans, had this to say:
“The decision to decrease resources into actively managed investments is just another headline intended to derail investor interest in active portfolio management. The move is designed to cut pverhead for them, pure and simple. They are a business, with a P&L to run. The retail investor is their customer, to whom they sell a product. Their products are investment funds and ETFs which investors purchase to gain exposure to various asset classes and sectors. They do not have a fiduciary responsibility to ensure that their customers appropriately diversify their investments and manage a robust financial plan. They are a solid investment manager and a well-run company. They have done much over the years to provide access to the financial markets. When the news media extrapolates their move to say (in no vague terms) that active investing is dead, they are insidious at worst, and negligent at best. The media is the enemy of the retail investor.”
Chart of the Week
So when do you think the high point of the market was in this recent rally (which happens to also be the all-time high at that point)? If you guessed “the day after President Trump’s joint address to Congress,” you would be right. Do we think this says something? Yes, we do. Ultimately, there is an extremely high correlation right now between the expectation of fiscal stimulus to the market and market price levels. Sentiment and confidence in the likelihood of Trumpian agenda implementation were at their highest the day after that speech. Market volatility is highly likely, for right or for wrong, to move lock step with expectations around President Trump’s political capital and sentiment.
Quote of the Week
The man who is a bear on the future of the United States will always go broke.
– JP Morgan
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I wish I could close you out with a final number for markets in the month of March and Q1 overall, but as I am typing this we haven’t quite finished out, even though by the time you are reading this we probably have. What we do know is that Q1 has set a good tone for markets in 2017, and that sentiment and bias are skewed towards the optimistic side, which enhances risk to some degree and reduces the return premium to some degree. In short, it is no time to believe thoughtlessness is a virtue, and it is no time to become complacent. But thoughtlessness and complacency are not in our vocabulary. We work to the end of managing risk and reward trade-offs for our clients, and doing so with their particular goals, needs, and objectives in mind. It is an utterly thrilling process, and we think we’ll keep it going in Q2.
Originally published on Dividend Cafe.
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