Only One Side to Choose
Suffice it to say, it has been yet another intense week in the news cycle. I am old enough to remember when the financial media was up in arms as to whether or not we were going to war with North Korea (i.e. last week); this week, it was the President’s business councils (made up of prominent CEO’s) that have blown up. The market had rallied quite a bit this week, making back up the drop from last week, but then gave it all up and then some Thursday as discussions have moved back from the threats of foreign news stories to the threats of domestic ones. We tackle the realities of stock market worries this week devoid of “headline exegesis” – and instead, wrapped up in the timeless principles that we are certain will serve investors better. This week’s is a particularly readable and digestible trip through the Dividend Café, so read on through …
Our Side of the Stock Market Debate
Our thought early in this calendar year was that a combination of Trumpian policy particulars and overall market valuations meant investors would be better served by selectivity than passivity in their stock allocations for 2017. In other words, we were not ticking down our allocations to equities, per se, but were recommending a change in how one composes their stock allocation – namely, by focusing on individual company opportunities instead of the broad market. We stand by that advice right now, though now make the recommendation with even more intensity.
To be clear, we know not when overall market valuations may top. We buy into the argument that they are reasonably close to full-value (across the whole market), but reiterate that valuation is not a timing tool. We do not know when market sentiment may reach maximum saturation, let alone when things like margins may actually peak. As I will never tire of writing, attempts to broadly time market exposure are futile, dangerous, and often fatal.
So what am I saying? Within one’s proper exposure to equities – determined through their specific financial planning, risk profiling, cash flow need, and specific needs assessment – we want to see that equity allocation composed of high-quality companies, that pay above-market levels of dividends to shareholders, and grow those dividends reliably and consistently. It is a core investment philosophy that has served us very well for a long time, and that we believe will produce successful client outcomes (the entire goal of all of this). We can study with the gift of hindsight what periods of time this philosophy proved to be more opportunistic, and what periods its relative defensiveness were less necessary, but on a go-forward basis, our reiteration of selectivity is based on:
- the secular need for greater income,
- the relative valuation benefit this sector offers compared to the overall market,
- the superior culture we think is often (not always) embedded with shareholder-friendly policies like this,
- and finally, (and least significantly) our tactical reading of the landscape:
- selectivity allows us to own what we want to own,
- and more importantly, not own what we don’t want to own
It’s all in the price – or, what to do if you want some juice
If one was reviewing their asset allocation, felt a higher exposure to growth (with accompanying volatility) was desirable, but felt a bit uncomfortable with U.S. equity allocations – if one wanted a market exposure right now that might represent a more attractive entry point than various alternatives, what would one do?
Emerging markets. Also selectively. You take on currency risk, geopolitical risk, and systemic market risk (“but other than that …”), but you right now would receive a starting valuation that suggests a very attractive long term result, and significant growth that stems from demographics, monetary advantages, and the historical juxtaposition we find ourselves in (namely, the ascension of a middle class in third world countries).
Conclusion – with no real forecast on the next ten weeks, we would suggest that over the next ten years a greater allocation to emerging markets will serve investors well within their equity bucket.
Are we getting worried – China version?
Our periodic reminders about China risk stem from the revelations that August of 2015 and January 2016 provided to market actors – that the world economy has significant and systemic China connectivity. To the extent China has succeeded the last 18+ months in controlling the slowdown of its economy, we obviously have had categorically different global investment markets. We largely avoid direct investment in China because of “rule of law” concerns and corporate/banking debt excesses. But predicting when things there will turn in such a way as to negatively impact global conditions has been a fool’s errand (and it doesn’t get any easier forecasting an improvement effect, either). The concerns center around their reliance on an overheated property sector (I swear I’ve heard this story before??), but the commodity price indicators tell us expansion is healthy. Their central bank is in brand new territory, and the world of economic pundits is in brand new territory as well. Our posture has served us well: Avoid predicting the inherently unpredictable, but refuse to turn off the antenna as it pertains to China.
Are we getting worried – MLP version?
Oil and gas pipelines and the MLP sector (Master Limited Partnerships) gave investors fits in 2015, including ourselves. The sector has run into trouble again this year, though those results are much “less bad” for the high-quality names than others … It’s a fair question as to whether or not we feel anxiety over the state of the pipeline space, when frankly much of the environment for the space should be a tailwind! The reality is that the very attractive yields are not believed to be sustainable by too many in the space, and until that belief re-surfaces, this sector will not be bid up. We are patient and diligent, and that leads to a total counter-act towards anxiety. We are determined to be focused on financial stability, and not play speculation games about particular assets and resources. There is a very singular goal here – grow cash flow to unitholders. That mission continues, with rewards for investors who maintain that understanding.
Refuting the attack on quality
It is a rather intuitive fact of investing that the moments one cares about quality are generally when markets are under significant duress. Lower credit quality companies (balance sheet challenges or issues in the income statement) can be really attractive when markets are all humming along. Portfolio managers who value things like dividend coverage, free cash flow, equity-to-debt ratios, and other such “boring” metrics (that sometimes can’t hold a candle to things like “clicks” and “users”) can use the credit quality of the companies to reinforce their beliefs about overall financial stability. How do we know more stable companies represent better places to be in the distressed periods? History. What did a random week like last week present in terms of that downside volatility across various credit qualities (and by the way, we believe last week was a sad and media-induced sell-off not rooted in fundamental sensibilities)? It should be no surprise – lower quality companies did worst; highest quality did best.
You wanted high housing prices!
Long-time readers know I am an ideological critic of the rather bizarre idea that “promotion” of high housing prices is, in and of itself, a good thing. Natural and organic market forces (inflation, job growth, wage growth, supply/demand/etc.) doing what they do is one thing, and certainly if one is about to sell a home, a high price is more to be desired than the alternative. But the notion that promotion of permanently advancing housing prices should be mandate of public policy is not only foolhardy, and guaranteed to end in catastrophe, but it ignores an entire segment of the population. 18-34 year olds that now own 11% of all owner-occupied houses, and people 55 and over own 53% of them. When today’s baby boomers were 18-34, they owned 22% of American’s homes – half of the present level. Just ten years ago, those over 55 owned 43% of homes, so that number has jumped dramatically in the last decade. These numbers are hard to interpret any other way than a reflection of hyper-stretched affordability levels. Markets have a way of organically correcting what policymakers inorganically distorted.
Run it hot – not
My old Morgan Stanley colleague, Joachim Fels, now Global Economic Strategist at Pimco, is a seriously smart cookie. So it is with fear and trepidation that I have to take him to task for his piece this week suggesting that the economy needs to “run a little hot” for a while (Macro Matters, Pimco Investments, August 15, 2017). The reasoning for his thesis seems to be an opposition to the Phillips Curve thinking of our present Fed, and as Phillips Curve opponents, we are fine with this. But his conclusion is that inflation overshooting is not a big deal, will “overcompensate for past behaviors” (huh?), and will represent a “cushion against future deflation.” What was noticeably absent in his diagnosis is the impact on low-income workers and fixed-income seniors who would be defenseless against inflationary price increases. Sorry, but there is no free lunch in such economic management – and a cavalier attitude towards “hot” inflation is not just morally questionable, but economically frightening.
The paradox of productive growth
Artificially low interest rates boost asset prices, and creates wealth for those in a position to take advantage of the difference between the market rate and what economists call the “natural” rate in the economy. There is room for grown-ups to disagree, but one side would argue that this “manipulation” is an effective way to stimulate growth in morose economies. If the interest rate, though, is equal to (or higher than) the natural rate, those borrowing money in the financial system will be limited to entrepreneurs engaged in highly productive growth. It is a purposely simplistic analysis, but there is “productive leverage” and there is “unproductive leverage.” We are far past the point at which the excessively low interest rates of the last eight years have become nearly entirely centered around “unproductive” leverage, therefore building up greater risk in the economy. This is not a bearish comment, because we have incredible confidence in what the results would be when borrowing incentives are tied to the natural rate (growth-oriented entrepreneurial endeavors). But I want to continue writing about this topic, because the global dependency on low interest rates is of paramount importance to investors, and it is oh so easy to confuse the way low rates benefit passive investors as believing they are actually promoting structural growth. Let me summarize this way: Asset prices going higher is not the same thing as growing capital stock in the economy.
A review and announcement
So you are clear on the different messages and mediums by which we seek to demonstrate thought leadership and idea generation:
- This Dividend Café represents our WEEKLY investment commentary, combining timely market perspective with timeless investing principles
- Market Epicurean is generally BI-MONTHLY, also focused on investment commentary, but centered around much more complex and substantive themes in the capital markets. Each issue tackles a single topic, and we call it “deeper end of the pool” reading.
- Next month we are going to launch a MONTHLY piece centered around our Financial Concierge Services. It will not involve investment or markets commentary, but rather will be a multi-page value-added piece to look at timely aspects of estate planning, tax planning, tax law, legal needs, real estate, mortgage borrowing, elder care, and a plethora of other issues that we dive into daily for our clients, and that we have been remiss in writing about despite their central importance in one’s financial life. Further announcements are forthcoming!
- Finally, we have a weekly Dividend Café Podcast, we do a weekly Dividend Café Video, and we offer consistent content (always original) via Facebook, Facebook Live, Twitter, and LinkedIn. We even post photographs with various reflections on Instagram. Sign up or seek to follow, connect, etc. in any of these forums that you like, any time.
Chart of the Week
If I were to be worried about the tumult in President Trump’s administration reaching markets, it would be in the realm of small business optimism. Investors shocked at the market’s resilience to various “volatilities” in the political universe are likely learning just how severe the disconnect is now between Washington D.C. and investing markets. But should the decision-making that stems from optimism (or lack thereof) in the world of small business turn unfriendly, I believe that would re-correlate markets and politics. This bears watching…
Quote of the Week
“My reason for thinking that we shall have these wide fluctuations is that I don’t see any change in human nature vis-à-vis the stock market which is sufficient to establish more restraints in the public behavior than it showed over so many decades in the past.”
– Benjamin Graham
Originally published on Dividend Cafe.