A Week Without Trumpian Drama
We are purposely sending this week’s Dividend Café a tad early, because we know the Memorial Day weekend lies ahead, and that today some of you may already be checked out for a long and deserved weekend that doesn’t include reflections on bond spreads, fiscal policy, and earnings reports. Perhaps this Friday transmission will give you the best of all worlds – the thrill of our commentary, AND a long market-free weekend. With all that said, let’s get into it…
The sweet spot of economic boredom
The economy is not smoking hot. It may become such, and we do believe certain fiscal reforms, primarily centered around supply-side tax cuts and effective deregulation, would lend a significant hand to that effort. But the economy cannot be called smoking hot by any reasonable definition. Leading indicators are growing, capex demand is pent-up and very possible ready to break out, industrial production is growing, and manufacturing is expanding. All of these things are modest advancements, speaking to a “not-too-hot” economy, but also a “not too cold” one …
As for 2017 …
The dollar at a six-month low has been the factor that has either made people look best so far this year, or made people look the worst. We happen to have not believed in dollar strength in the face of five factors that every man, woman, and child already knew about and had already priced in, but we get plenty of other things wrong. In this case, the dollar has historically rallied in advance of Fed tightening cycles, and sold off in a “buy the rumor, sell the news” kind of way. This appears to be more of the same, and has had profound implications in one’s equity, commodity, bond, emerging, and currency investment results.
We should point out – at today’s level, while down in calendar year 2017, the dollar is essentially right back to where it was on election day!
The Fed has given some muddy clarity
Federal Open Market Committee (FOMC) meeting minutes came out this week and as expected, the subject of their balance sheet reduction was front and center. The Fed made clear that they do plan to reduce the assets on their balance sheet (lower the amount of reinvestment of bonds they own that mature, meaning assets “run off” and do not get replaced), but they added the caveat “as long as the trajectory of growth matches committee expectations.” It will be a gradual process, as expected, and they haven’t really indicated what size balance sheet they intend to be left with. Here is what we know: They were roughly half a trillion dollars pre-crisis, and are roughly $4.5 trillion now. We do not believe the size will drop below $3 trillion, which would mean a currency in circulation of $1.5 trillion and reserves of another $1.5 trillion. Their planned ratios have not been discussed in any public forum.
Now THIS is a new world!
How is it that companies have been able to grow profit margins as they have over the last ten years, so that earnings growth has exceeded revenue growth so consistently? Well, the most obvious reason is that companies can do a lot more with less people now. There are few research projects we enjoy more than ones we conduct in-house, and this particular project our Investment Solutions Managing Director, Deiya Pernas, took ownership of, and the results were startling:
In a nutshell, just note visually how many less employees are needed now for certain capitalizations of companies … And actually, this is not just showing how many less employees new economy companies need than old economy ones; for even old economy companies are generating more revenues and more productivity with less employees than ever before. An economic and earnings bonanza; a societal challenge, certainly.
The sustainability of financial relationships may be like your personal ones
We talk a lot about “valuations” and “reversion to the mean” in financial markets – the idea that there are historical valuation levels, and that generally speaking assets “revert” to the mean of those valuations through time (whether that means going higher or lower). But often times you will hear well-meaning financial analysts and pundits talk about “ratios” (the historical relationship between financial category or asset and another), and assert that those relationships revert to the mean as well. This is, unfortunately, lacking in empirical precedent. Many of us have personal relationships (maybe a friend, a sibling, a spouse) where there are periods of, shall we say, “volatility” in the relationship, followed by restoration of normalcy (reversion to the mean), and in that sense, financial assets can often do the same. Sometimes stocks may be really over-priced relative to bonds, but the valuation levels may reset through time to historical levels. However, sometimes that “often volatile” relationship with a friend or sibling, just ends. Normalcy does not resume. People separate, move on, give up. It happens. And likewise, sometimes a “financial ratio” just ceases to be. It is re-defined. It changes. To invest as if asset A must come down or go up to be in line with asset B requires two if not three levels of premises subject to risk. We saw this error as it pertained to gold/silver investing and also gold/gold miners investing over the last ten years, as unfathomable capital was lost chasing ratios that had been forever tossed to sea. Right now even analysts we respect are suggesting the same must happen as it pertains to U.S. vs. European stocks (which, by the way, it may very well prove true, but that doesn’t make it a compelling investment thesis). Valuations are a lot more reliable than relationships that have much more correlation than causation at play!
Emerging shiny toys look like this
How do we go about pursuing lower drawdowns in tough periods for emerging markets, higher returns, less volatility, and an all-around better experience in the world of emerging markets stocks? By focusing on high margin businesses, with an above-average Return on Assets, above-average Return on Equity, and above-average Return on Invested Capital. We want companies with pricing power (these aforementioned metrics pretty much validate if they have it) as we want the ability to over-compensate in the long term for any macro circumstance that could complicate things. Consistent and sustainable earnings growth is our aim; the price performance is a consequence of that.
The Indian case in point
Taking the rationale of the previous point to an application, Indian equities are largely considered the cream of the crop in the Emerging Markets world right now. And yet the EM space overall trades at 12x earnings while Indian markets average 18x. Do the fundamentals favor India as an investible space? Sure, but if valuations already reflect those fundamentals, the opportunity set for investors is diminished. Selectivity matters. This is the essence of our Emerging Markets belief system!
Best news for retail was already known
It would appear safe to put final nail in the coffin for the ill-conceived Border Adjustment Tax idea. In a week that saw abysmal results for yet another slew of retailers, it must at least be nice for them to know that the Treasury Department themselves are now saying a Border Adjustment Tax is not going anywhere.
Chart of the Week
We have made the political, administrative, and macroeconomic point for months that the energy sector is attractive. Now let’s make the valuation point … In this week’s Chart of the Week we look at P/E ratios for the last ten years in each sector of the market, and the yellow diamond represents the current level. Only the energy sector is beneath it’s average.
Quote of the Week
Business and society are intertwined, the best businessman, the best investor, has always been a social scientist. He has always been concerned with people; he’s always tried to figure out what people want and what the people’s needs are.
- Michael Milken
Originally published on Dividend Cafe.
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