Human Nature and Your Portfolio
What a strange beginning to September it has been. Markets dropped over 200 points Tuesday after the long weekend, the theoretical causes of which we delve into in this week’s commentary, and rebounded Wednesday. The energy sector rallied quite a bit this week. Bonds continued to catch a nice bid as rates dropped further. New national weather disasters set to replace Harvey on the national stage. And all the debates about risk-on / risk-off came back into the center. We cover the most important lesson in all of investing to kick off this week’s Dividend Café, and then we really go all over the map! Let’s get into it…
The heart of the matter
Not only did a recent newsletter from a mentor of mine provoke this, but I am a month out from his annual symposium – an event I have never once missed (and do not intend to) – and I felt inspired to share in the lead-off to Dividend Café this week a nugget of wisdom that is absolutely central to everything we believe and everything we do at The Bahnsen Group: The successful execution of an investment plan will always and forever be a result of behavior, not intellect; of temperament, not complexity; of wisdom, not knowledge. We work and work and work in capital markets, and I have a very hard time believing any financial advisor studies more than we do, or cares to be informed and prepared to the degree we do. And yet all the content digestion and content creation in the world could never hold a candle to the need for proper behavioral guidance and decision-making. It is the core of our value proposition – aiding our clients in the not-always-easy task of avoiding the big financial mistakes. We are fighting a war against human nature in our daily calling to assist clients in achieving their financial goals (with battles against media influences and doomsday bloggers being peripheral battles in that greater war). Human nature will lead even intellectually rigorous investors to do the wrong thing at the wrong time. We are determined to win that war, and we win it with your trust, and our trustworthiness.
So about that Tuesday selloff?
There is something painfully contradictory about following a paragraph that establishes long-term behavioral disciplines over emotional responses as the primary determinant of investor success with a paragraph discussing one measly day’s market action. However, I present this information NOT to play into the silly discussion of what one day’s market action means, whether it was a -200 point day or a +200 point day, but rather, to demonstrate the very point that these things are not actionable, and often dangerously discussed events. If one watched the news Tuesday they may have concluded that we were down 200 points because of the hurricane damage (over a week late?). If one watched the news Wednesday they may have concluded that we were up because of the hurricane (all of a sudden it turned into a positive around higher energy prices?). One may have concluded that it was North Korea (because a nuclear war is good for, ummm, 200 points down?), or concluded it was challenges with President Trump’s agenda (deja vu all over again). Do you want to know why the market dropped over 200 points Tuesday? The answer is that the market doesn’t need any reason whatsoever to do so – the market is a complex, layered, and multifaceted organism responding to trillions of data points second by second, and has never provided anyone clarity on why it does one thing one day, and another thing the next day. Traders unwind trades. Speculators get beat one day and vindicated another (but never all at once, or there wouldn’t be any beating or vindicating to talk about, would there be?). A market in a meaningful bull run like this one will have days that go down. If it helps you to assess blame to North Korea, or a hurricane, or to USC’s need to stop Stanford’s rushing attack, I say have at it – just don’t actually try and do anything about it.
The bond market a bigger deal than the stock market
This issue of the ten-year bond yield is a big, big deal. One cannot have equities rallying behind growth expectations, and have bond rates falling due to low faith in growth expectations. One guest, I recently appeared on CNBC with made the comment – “we have a bond market believing the inflation data [which is weak], but not believing the growth data [which is stronger].” I think that’s very astute, and that the prudent positioning right now is to maintain defensive bond weightings biased towards increased interest rates, but not dramatically so. In other words, growth is strong enough for a 2.5% ten-year, but inflation not high enough yet for a 3%. And as for the risk that rates drop further? That is always there, especially in risk-off circumstances, and therefore why bonds belong in some small degree in a properly asset-allocated portfolio.
Consensus or Contrarian?
One thing that would kill my research project on Japan as source of potential dividend growth equities, is if it remotely struck me as a “consensus” viewpoint. Being late to a position everyone else already adapted (the investment practice of choice for 90% of investors) is a sure-fire way to deteriorate results. However, the data here is quite remarkable. In 2013, over $150 billion (net) came into the Japanese stock market from foreign investors. Another $23 billion in 2014. But in 2015 it dropped to just $3 billion, and in 2016, the net number was NEGATIVE $40 billion. In 2017 we are looking at just $2.7 billion into the space, meaning, there has been negligible interest in Japanese equities from foreign investors for quite some time. (1)
Fundamentally speaking …
Earnings per share in Japan are up nearly 30% over the last 12 months. The caveat – we’re comparing a number that is against an extreme trough in earnings, therefore subject to overstatement. The validation of this thesis – that Japan has breathed out the “hangover” (over a decade long) of its great deflation, and that individual operators could represent attractive secular dividend growth for U.S. investors – will ultimately come down to (a) Proper affirmation of the fundamentals around earnings, cash flows, and dividends, and (b) Comfort and confidence that the central bank intervention of the last year is not the sole horse on which those hypothetical fundamentals ride.
Japan as a … risk hedge?
The other angle we are digesting is the idea that there may be a particular risk hedge in a long-Japan equity investment (even as it invites a different risk, of course). That is, paradoxically enough, that if U.S. interest rates rise, it should benefit Japanese equities. You will note in the chart below how dramatically the Yen/Dollar exchange rate has correlated with U.S. interest rates. At least from the currency component in Japanese investment, this would likely mean a positive result should U.S. rates rise. Now, the inverse is at play too – that is U.S. rates drop it could hurt the Yen. If that risk was greater than the risk of higher rates, one may want to take currency out of play altogether (taking their Japanese equity exposure with currency hedged). This too remains a part of our due diligence.
Did someone say jobs?
I hate even covering the jobs data every month because not only are all monthly data points irrelevant to what we are doing, this one is especially irrelevant (being notoriously lumpy, etc.). 156,000 jobs were created in August, below the 180,000 projected number. Average earnings were up 0.1%. It was a soft report. One analyst (Brian Wesbury at First Trust) pointed out that August has been notorious for later revisions, but we shall see.
The end of a credit cycle seems quite particular
The headline is very sarcastic – though the end of this credit cycle is going to happen, it has not happened yet. But in recent months we have seen high yield bond spreads move higher, though a look under the hood tells us something quite interesting:
You will note in the chart above that spreads in Industrials, Materials, and Financials are really quite flat since the beginning of the summer; all of the spread widening has taken place in Energy. There may or may not be good reasons for this (though it may do one well to note how spreads utterly collapsed throughout 2016 after it became clear that the U.S. energy sector was not going to actually fold up with oil prices below $50). However, a credit cycle applies to all credit – to the entire ecosystem of corporate debt. Thus far anyways, what we see in the junk bond market is highly concentrated in energy.
Proving that everyone is wrong
A thought occurred to me as I was completing this weekly writing that I believe is quite important to our understanding of present markets. I was reading a report on a completely different topic, when this factoid hit me in the face: High yield bond spreads have widened a bit as we discuss in the preceding paragraph; U.S. equity markets, though still awfully close to all-time highs, have at least been experiencing some resumption of stock-like volatility the last month or so; and yet, with everyone telling us that North Korea and risk-off are the game changers, emerging markets debt has continued to rally. Their yield spreads have tightened, not widened, which is a direct contradiction to the Korea is driving risk fears (“I am afraid a nuclear flare-up will hurt my U.S. stocks but I will pay more money for the debt of the country next door”). These spread indicators tell us that traditional factors – inflation expectations, currency, economic growth, and with stocks, earnings, are driving asset prices.
Chart of the Week
Why was the market down/flat in 2015, and why has it rallied so much in recent times? I am unable to think of a chart that makes the case for causation better than this.
“The data are weak creatures. If you torture them enough, they will always confess.”
– Alfred Sauvy
We will leave it there for the week. To our clients, I can say that we have a lot in mind right now regarding portfolio positioning and are less than a month away from our annual meetings with every portfolio manager we work with. There is heavy discussion amongst our Investment Strategy team right now about key allocation decisions, and that right balance between needed return pursuit and appropriate defensiveness. The theses we carried into 2017 have served us well, and we want to be very deliberate in how we allocate or adjust in Q4, and going into 2018. And yes, more than anything else, we want to aid you passionately in avoiding the temperamental mistakes that are of primary importance to investors.
This week’s Dividend Café is dedicated to our long-time clients, Dolores Bagne (California), and Geoff Donnan (Florida), who lost battles to cancer last week. Geoff had been a client for 13 years, and Dolores for 9 years, and both were just treasures of human beings, and will be sorely missed. I adored them both, and thank God for our years of work with them. Truly special people.
Originally published on Dividend Cafe.