Is a Bear Market in the Cards?
Dear Valued Clients and Friends,
As mentioned last week, this week’s Dividend Café is coming to you from the high seas of the Caribbean where I am enjoying a week off for my kid’s spring break. I haven’t quite finished one book per day but I am close, and beyond the reading and beauty of the ocean, the time with family has been utterly delightful. I am incapable of totally turning off from the markets, much to my wife’s understandable chagrin, so there are some interesting reflections to focus on in this week’s Dividend Café.
Q1 didn’t embarrass anyone, or did it?
Look, even most perma-bears came into Q1 pretty quiet, not exactly screaming their “stocks are going to collapse” message from the hilltops. Most perma-bears have mastered the art of just being vague enough that they can essentially stay to the sidelines while markets rise, ummmm, 14,000 points (real number for the Dow last eight years), and then jump out of the bushes after a 1,000 point drop to say, “I told you so.” However, bearish market forecasts for Q1 were not common as Trumpian momentum was still in play and earnings results were presciently expected to be solid. Bond markets stayed in the range most predicted, with the 10-year yield not breaking out above 2.6% but not reverting back below 2.3% either. Even most alternative strategies did quite well in Q1 as best we can tell from our surveying of the land (both in-house and around the neighborhood). So all in all a great quarter for forecasters? Almost. But we forget the area where more reputations are ruined for those who dare more than anything else in financial markets – CURRENCY. Waves of predictions that dollar strength was the new normal, and that it would bring emerging currencies, bonds, and stocks down as it ascended, have all fallen flat (or actually, much worse than flat). Not only did the U.S. dollar index drop 1.74% in the first quarter, but it declined against every single major currency in the world – the exact opposite of what were mostly pretty smug, confident predictions. We would still watch European growth and inflation – any dollar bear thesis has to account for the secular headwinds in the Euro – and we wouldn’t enter Q2 with any more of a quarterly projection for the dollar than we cared to make in Q1. But it is a helpful reminder that the world of currency speculation is not a world where one spends their days (or nights) celebrating. And forming an investment philosophy around someone else’s highly vulnerable views on currency and foreign exchange is possibly pathological.
The market’s policy dream
There are so many things at play right now in how markets discount their expectations for the Trump administration policy agenda, that we may lose sight as to what the markets most want to see. Understandably, investors have to reconcile what they want to happen with what they expect to happen, and there is a need to understand both the politics and the market’s response to the policy particulars, but I do want to think it is helpful to look at where we believe the greatest market impact would come from.
We have said since the election that we think energy infrastructure is a major, major story (from a market standpoint) in the Trump administration. We think he will succeed in achieving much of what he wants here. This will prove to be stimulative, in our opinion (for the broad economy), and it will prove to be beneficial to that sector.
The overall deregulatory efforts matter too. The market has most focused on this in the sector of financials, and that is understandable too. From the way Dodd-Frank gets implemented, to Fed stress tests, to capital rules, to replacing key Fed personnel involved in oversight, there is, again, an ability to effect change here that the market is likely to embrace without the complexity of Congress and legislation.
We then get to tax cuts and tax reform. These are the issues markets care about the most, and they happen to be the ones most complicated from a political standpoint. There are so many ways it could go, including a quick corporate tax cut that passes easily, with a promise to re-address tax reform later. The apparent resurrection of an ObamaCare repeal bill may change things as well. So while we wish there were easy predictive factors to look at in all of this, there are not. What we do know is that the market wants something to get done, and has priced much of that in.
The silver lining for GDP growth
We hear a lot in the press that consumer and small business confidence is picking up, but we haven’t [yet] seen that translate into actual revenue growth. However, we do see it leading to an increase in credit, and as the chart here from my friends at Macro Intelligence 2 Partners, shows, that credit growth generally means more capital expenditure spending. And yes, that ought to lead to GDP growth.
Cette élection me fait peur
(Okay, fine – it wasn’t the two years of French I took in the 1980’s, I used Google. But the translation is still right!)
Yes, this election in France coming up does scare me, though not for how it may affect my client portfolios. The “first round” of the election will take place on the 23rd, and if there is no 50%+ candidate (which there likely will not be), there will be a run-off between the top two candidates on May 7. I won’t bother to litigate in the Dividend Café the pros and cons of the various candidates, but I will say this election makes the U.S. election of 2016 look like a romantic comedy. Ultimately, regardless of the exact way this plays out, we already know the following: An increasing amount of French citizens are dissatisfied with the European Union, and although their favored candidate this cycle may be too extreme to cross the finish line, the trajectory appears to be a growing increase across the continent of those expressing Euroskepticism. Our expectation is that a reasonably left-of-center candidate will win this race in the run-off on May 7, but obviously there are those pointing to Brexit polls to suggest this outcome is far from certain. We tend to apply this to client portfolios in a more reasonable manner: We are actually not expecting a shock out of this election, and yet we believe what the potential shock represents (more trouble for the Brussels establishment) is baked in for the future regardless of who wins.
A Generation of Investing in One Chart
What you see here is not the performance of the Treasury Bond Market for investors, but it would be if you turned it upside down. “Yields” (the income a bond pays dividend by its price) are directly and completely INVERSE related to “prices” (what someone will pay for a given bond in the market). As interest rates drop, it pushes bonds that pay higher interest rates UP in price, and vice versa. As this chart shows, bond yields collapsed throughout the Depression as deflationary forces killed the U.S. economy (no surprise there), and yields skyrocketed up creating a huge bear market for bonds as the growth and expansion of the post-war 50’s and 60’s turned into inflation and stagflation of the 1970’s (this was policy-driven more than necessary happenstance). In the early 1980’s, the combined efforts of a strong dollar policy in the Reagan administration and a concentrated effort to destroy inflation by Paul Volcker (who then chaired the Federal Reserve) led to a generational drop in bond yields, bringing housing prices up, and creating a bond bull market for the ages. The last eight years has been a very rough period for those forecasting a return to higher rates in the bond market. With that said, risk/reward trade-offs make betting for very low rates forever a difficult proposition. We do not know if a bond bear market is about to commence, but we certainly believe the bond bull market is over.
But I only buy short term bonds?
One way to defend against the investment pain of holding long term treasury bonds and so forth if interest rates move higher is to shorten duration (i.e. instruments maturing in one year, for example, have less price risk should rates go higher). And it is true that the defense here is greater if that were the only criteria (avoiding the risk of interest rates going higher and lowering your bond price). But short term interest rates beneath the rate of inflation do not exactly represent a great investment thesis either; they simply lock in a known and reasonably acceptable LOSS. Let’s say one finds a one-year CD or Treasury for 1%. I actually see some two-year CD’s now at 1.5%. The core inflation rate is currently 2.3%. These instruments are taxable as ordinary income. So depending on tax rates, the nominal after-tax return is somewhere around 1%, and the real return is somewhere around -1%. Short term parking lot for cash/savings? Sure. Actual investible thesis? The day locking in an assured loss is a viable investment thesis is the day crazy has won.
Could European investing join our selectivity theme?
The shared currency of the Euro and shared central bank of the ECB (and of course, shared bureaucratic union of the EU) has forced us to view Europe in the economic/investing lens as a monolithic issue for quite some time, and that monolithic view has been quite negative. However, we are seeing greater divergence in economic outcomes and outlooks than any time since before the financial crisis. Holland, for example, is showing interesting turnaround. Italy, on the other hand, is getting worse by the day. We do wonder (no conclusions yet) if there will be an opportunity for selective value in selective countries.
Banking on Banking
The Price for Trust
We operate off of a reasonably simple expectation at The Bahnsen Group – that our clients will trust us in the advice we give them, and that they will do so because we are at all times worthy of such trust. “Proof” is an evasive concept in most fields, but particularly so in financial management. We do more study and research and data analytics than anyone I have observed in this business, but we do not teach clients about the superiority of dividend growth investing, for example, because we can “prove” it will outperform a different market approach over the next 12 months. To the extent we can “prove” that a particular outlook or approach or philosophy has performed a certain way in the past, even that does not prove anything about the future. My mentor, Nick Murray, has beaten into me for nearly 20 years the importance of “moral authority” in how we stand as investors. We have the competence, track record, research vigor, commitment to learning, discipline of execution, and most importantly, obsession with the best interests of our clients, to deliver investing outcomes to our clients that will meet and exceed their goals. We substantiate this morally by maintaining firm convictions, not wavering from what we believe, and telling clients the truth even if we know they do not want to hear it. Why do I believe clients should trust us, and be assured of our trustworthiness? Because when clients most want us to say, “don’t worry, we can get you out of the market when it is going down and back in before it starts going up,” we say to our clients, “no, we can’t – and neither can anyone else.” Moral authority comes from truth-telling. We tell our clients the truth about capital markets, about the realities of investing, and about the impossibility of risk-free returns. It is in those harsh realities that you can find trustworthiness. It is the “guaranteed 8% return” one should run from, if for no other reason, than the fact that it is a lie.
Chart of the Week
We write last week about the various factors that may prove to be catalysts to a turndown in the markets. We follow a number of indicators that have historically proven to be useful clues to a pending bear market. The following checklist from our friends at Strategas Research (this one dated April 3, 2017) is rather substantive in surveying the lay of the bearish land …
Quote of the Week
History doesn’t just happen. People make it happen. By history we mean not only the great affairs of state but also the happenings in science, in the arts, in the field of sport and in all the other fields of aspiration and endeavor. Taken altogether, these mean civilization. In recent years we have had to face the prospect of a catastrophic end to everything. But we also face a livelier and more likely prospect – the prospect of creating throughout the world a more splendid civilization than was ever known before.
– Henry R. Luce
Originally published on Dividend Cafe.