Why The End Of The 15-Month S&P Rally Is Actually A Gift

Posted: Mar 01, 2018 12:02 PM
Why The End Of The 15-Month S&P Rally Is Actually A Gift

Some people may feel February being the worst month in markets since the ancient history of 2016 cannot possibly be called a "gift," but they may feel differently after reading this week's Dividend Café.  Yes, the extremely strong January of this year was followed up by the first negative month in markets since October 2016, the longest monthly winning streak for the S&P 500, well, ever.  But jump into the Dividend Café for a better understanding of what it means and where we go from here!

February redux

So yes, the S&P 500 enjoyed a 15-month run in which the market index rallied 36%.  And yes, that run has come to an end.  Depending on the index, stocks were down roughly 3-4% in February after their 5%+ rise in January.  All of the losses for the month came essentially in three particular days, but there was a tremendous spike in volatility for the month with large down days and up days following each other on multiple occasions.

The truly unique nature of this month's headwinds was that for the first time in what feels like forever, there is no whisper of "slowing earnings" behind the decline, or "economic distress."  On the contrary, equities declined in February as interest rates moved higher in response to positive economic growth.  It does not make the nature of the equity re-pricing less legitimate, but it does change the context when causation is positive vs. negative.

The first negative month in forever resulted in a market that is, well, still up on the year.

What has us optimistic on equities?

This.  Enough said. (Okay, I have to say more - it is the money that flowed OUT of equity funds in February).

Click here to view chart.

Wait, there's more

The take from equity bears for many years has been the idea of "peak earnings," or more specifically, "peak margins."  Essentially, the thesis was that earnings had grown in a big way, as profit margins had expanded dramatically, but that as margins went as high as they could go, profits growth would taper out as top-line revenues were not growing enough to justify the continued rally.  Fair enough, in theory.  But in practice ...  78% of companies beat top-line revenue estimates in Q4 (the highest percentage to do so in the history of this data being tracked).  Profit growth appears to be coming in at 15% year-over-year for the quarter (pre-tax reform).  Ay yi yi.

A trade war by any other name

As of press time, there was an announcement that the Trump administration was about to announce sweeping tariffs in the steel and aluminum industry, and then there was an announcement that amongst division in the administration the announcement was on delay.  Markets had been down on word of the tariffs coming, and then rallied on news of the delay.  So we shall see.  There is no scenario by which we see protective tariffs as being a bullish development for markets.

Narratives can be wrong.  Or, they can be REALLY wrong.

I have been critical the last several weeks of the simplistic belief that rising yields are automatically negative for the bond market.  The pedestrian assessment is that a rising bond yield makes the relative attractiveness of bonds to stocks less attractive, and therefore higher interest rates are a negative for stocks.  And I have responded that this assessment ignores the other variables that need defining to make such an assessment - such as economic growth, the margin in spread between bond yields and earnings yields, inflation expectations, etc.  In other words, we don't know enough information when we merely say "rates are going higher" to say that "it will be bad for stocks."  And as I have argued, rates going higher for inflationary reasons are bad for stocks and bonds, but rates going higher due to productive growth can be quite good for stocks.

But let's put the economic pontificating aside and just see what history tells us.

Click here to view chart.

To hawk or not to hawk

The prevailing belief in our thinking is that the Fed will be as hawkish as can be without actually being really hawkish.  So yes, modest reduction of their balance sheet (behind total telegraphing of such, and yes, 25 basis point increases in the fed funds rate - one at a time - three this year - headed to a more natural rate.  Is that hawkish?  Well, it's more hawkish than cutting rates.  But the point is that even in that "sort of tightening" they are still allowing a real fed funds rate to be negative (net of inflation).  If the Fed proves to be more hawkish than we think, then on a short-term basis we imagine emerging markets may underperform.  But if we are right, we think they over-perform.  If the Fed's hawkishness exceeds expectations, we also think Japan will outperform on a short-term basis.  We think we have both sides covered.

But but but ...

There is no reason to own or not own Emerging Markets based on what the Fed does or doesn't do in the next six months.  Same for Japan.  And the same thing applies to what the Bank of Japan does.  Our thesis is fundamental, lasting, and based on the economics of company profits.  Period.  Always and forever.  These other macro functions may affect weightings and may affect the volatility and sentiment (and certainly the noise) along the way.  But if we are investing in companies, and that thesis is anything other than those companies, their prospects, their cash flows, their growth, and their dividend (the measurement of all the rest), we are doing it wrong.

The good news and bad news about REIT's

We own a couple very purposely selected publicly traded Real Estate Investment Trust stocks in our dividend portfolio (we have different real estate exposures in our alternative allocation), but it is important to clear up a misconception about REIT's.  One is that they are ultimately a by-product of interest rates.  Meaning, when rates go down, they do well (e.g. in 2000 rates fell a bunch and REIT's were up a lot), and when rates go up they do poorly (e.g. oops - I don't have an example).  On a year over year basis, in 18 years, the ten-year treasury yield has been up seven times, and in all seven years the REIT index had a positive return.  The worst REIT year was the year interest rates dropped the most (take a guess - 2008).  So the good news is that this understanding of REIT's and interest rates is flawed, fallacious, and deeply misunderstood.  The bad news is that the data does suggest REIT's are highly correlated to something - and that something is economic growth.  We are willing to be invested in economic growth, and to make specific selections about where there may be value and dividend income growth in this environment (it's gotten harder).  But are REIT's magically uncorrelated to everything and anything?  Of course not.

A glut of passivity and activity

There are 8,255 hedge funds managing $3.2 trillion today.  That is too many.  A lot of them are probably going away.  There are 1,831 ETF's (exchange traded funds) managing $3.4 trillion today.  That is too many.  A lot of them are probably going away.  The number of hedge funds, mutual funds, and ETF's is irrelevant to most investors, as is the amount of money in each sleeve.  What is relevant is their holdings, their composition, and the way the structure of the financial system may or may not affect them.  Do unsophisticated investors panic out of ETF's and mutual funds in equity corrections, exacerbating short term technical issues?  Yes, they generally do.  Does that affect smart investors?  It ought not to.  Holding periods of stocks have collapsed - from 8 years on average to less than 2 years now.  Who has made the most money - those with longer holding periods, or shorter ones?  We hope you know the answer.  Passive, active, mutual, exchange, whatever.  Own the right companies and behave smartly when things get sketchy - to that end, we work.

Chart of the Week

Why would need active management in the quest for dividend income, let alone divided growth?  Note the number of companies in the S&P 500 now offering a dividend yield higher than the 10-year bond yield.  It has twice since the financial crisis been over 60% of companies in the famed index offering dividend level > 10-year bond yield; it is now down to just 20%.

Click here to view chart.

Quote of the Week

“You drown not by falling into a river, but by staying submerged in it.”

-- Paulo Coelho

* * *

The new Fed chairman handled himself quite well this week in his first ever Senate testimony.  Monetary policy, combined with the bond market, combined with expectations around inflation (all three things sort of conflate together, by the way) really are the big driver of how equities will be priced in 2018.  Earnings, of course, matter most, but we are (and the market is) taking for granted that earnings will be solid (in an upward trajectory kind of way).  So the bond market is in charge, and the central bankers have to dance with that.  The new Fed chair has a worthy opponent.

David L. Bahnsen writes at the Dividend Café.