As of press time we are sitting about 400 points to the upside on the week, a number that could be quite different by the time you are reading this, and a number that may be surprising given expected volatility around the Syria strikes over the weekend, or a number not at all surprising given the contained nature of those strikes, and the reasonably quiet week on the trade front. Either way, at least for the time being, volatility has quieted a bit and all eyes are on earnings season which is now in full effect (the heaviest of which will be the next two calendar weeks). From re-validating assumptions around capital allocation plans, to discovering potential capex intentions, a lot rides on the forward guidance portion of this quarter's earnings season. We are going to apply what capital allocation plans from corporate American means to you in this week's Dividend Café, and generally dive into a few areas that will leave you aghast
Why be optimistic?
We have been banging the drum for some time that dividend increases are coming (a positive), share repurchases are coming (a positive), new capital expenditures are coming (a positive), and overall balance sheet improvement is coming (a positive). $2.4 trillion of cash on the balance sheets of America's non-financial companies (S&P 500) is an all-time record, and it is only going to be going higher from here as the impact of tax reform becomes actually realized.
Taking some air out of the bears
The "over-valuation" argument is one of the most common arguments in the public square against stocks, and yet time and time again this argument ignores the most obvious nuance in the facts that matters: The "over-valuation" is highly concentrated in a very, very small number of companies, bringing the overall "valuation" up, but in fact speaking to their own over-valuation more than the broad market or its many sector constituents. Over-valuation may apply to a diagnosis of certain parts of the market, but that is best remedied with selectivity and discernment.
But the fear is so much higher, right?
Some had been pointed to the elevated VIX as signs that "fear" was just plain higher in the market now, indicating economic headwinds that could bode poorly for stocks. In fact, the VIX has collapsed from its February levels, and while it sits above the January lows, it is in a healthy, normal spot historically. But let's ignore the VIX for now, because I am not sure I will ever pay attention to it again now that its volume is so controlled by the technical factors of exchange-product ownership.
High yield bond spreads are a vital tool at measuring risk (and complacency). The higher the spread, the more risk investors are pricing, and therefore more compensation they are demanding for that risk. Inversely, when spreads collapse, it indicates the perception of less risk (for right or for wrong). This is a marketplace indicating the votes of hundreds of billions of dollars of economic actors with real skin in the game. I would anecdotally add that high yield bonds have a high correlation to oil prices at times (like now), and oil's resurgence is surely behind some of this. However, a skyrocketing complex of fear and panic is completely incompatible with tightening spreads in the high yield bond market. And here we are.
State of the [global] economy post-tax reform
Readers will recall how consistent the theme was last year of globally synchronized economic growth. The U.S. economic conditions were improving, and that received the "kicker" late last year of tax reform. But Europe, Japan, China, and emerging markets were also experiencing robust economic growth (some more robust than others), and the landscape of harmonious GDP growth was a very appetizing landscape for risk assets. But is that momentum slowing, accelerating, or something else? The data is mixed. Europe's economic growth is slowing, and we would argue is most vulnerable as the ECB begins pruning the patient off its monetary medication. Uncertainty abounds around trade/tariff matters, around FANG regulation, around China, and so forth. And yet, we see positive conditions in emerging markets, and the beginning impact of corporate tax reform boosting U.S. business investment. Excessive conviction one way or the other is a poor idea right now. The positive impact of tax reform will take time, and should not be missed.
So why should trade deficits not worry us more than a trade war?
In fact, it's not even close. Read more at our Market Epicurean site if a deeper dive on this appeals to you!
When 10% never equals 10%
We know the historical long-term return equity investors have received, and we pretty much like the return long-term equity investors have received. But the real reality for those who equate "holding the market" with "getting that market return each year," is that, well, the market almost never offers it's average yearly return, yearly.
Understanding oil prices
So yes, the price of oil has been hitting multi-year highs, regardless of which benchmark you use. But sometimes a very particular hub in a given region will see a very different price than even the price set by their own benchmark. For example, U.S. oil prices are generally considered set by WTI Crude Oil benchmark (West Texas Intermediate), yet right now certain hubs in the Permian Basin are seeing prices WAY below that standard oil benchmark level. Why would that be? Because buyers are having to use more expensive ways of getting the oil transported to them (like trucks) - forcing them to pay less for the oil. Why would that be? Because of inadequate pipelines to handle the transportation ... Production levels are so healthy in the Permian Basin, pipes can't take it all to final destinations, forcing more expensive means of transportation (adjusting select oil prices). We are under-invested in energy infrastructure, my friends.
Re-visiting our love of private companies
Speaking of Market Epicurean, I do intend to write a white paper more appropriate for that paper in the near future on the case for private equity as a vital asset class for the high net worth investor. But while you wait with baited breath for that deeper dive, I think it is fair to say that there is a very basic element that should be repeated about investing in private companies: For most companies (not all, but for the vast, vast majority), the highest percentage growth they will ever enjoy comes in their pre-public years. Of course, public market access may push them into the stratosphere, which is why I am carefully referring to percentage growth. Companies scale before they go public. They become survivable. They become legitimate. There is different risk, for sure, but in terms of percentage growth, generally speaking there is much more to buy in pre-public equities than there is in the public markets. Now, public companies offer liquidity, balance sheet strength, competitive advantages, cash flow maturity, and so much more. But to the degree that investors are paying a higher multiple for companies with lower % growth in public markets than they are for companies with higher % growth in private markets (incontestable), there is an argument to be made that "growth" makes more sense from a risk/reward standpoint in the private equity space (a similar argument to what we make about emerging markets). More to come on this important topic ...
A little primer on behavioral finance
I talk so much about the broader categories of behavioral problems among investors, generally excessive euphoria after an asset has mostly peaked, or excessive pessimism after an investment has mostly bottomed. The errors that come out of these human nature realities of fear and greed are many. But behavioral errors can be more nuanced than those basic primary categories. Other frequent examples include:
- Availability bias - making decisions based on just information that is easily accessible, and not that which is most important
- Anchoring - holding tight to a small amount of information rather than considering expanded facts and perspectives
- Hindsight - believing we know what an outcome would have been, when in fact, we knew it only with the gift of hindsight.
- Confirmation bias - seeking information only to corroborate what we already believe
- Pattern seeking - looking for, and believing to have found, order and investible patterns, where in fact no repeatable pattern exists, and we are being "fooled by randomness"
- Overconfidence - excess confidence or euphoria; failure to respect risk or downside possibilities
These are not merely errors that we encounter and seek to counter-act in our clients; we have to be vigilant to avoid such errors ourselves. Any investment process you encounter not taking seriously the realities of human nature and taking steps to immunize against such propensities must be rejected.
Chart of the Week
This bull market we have been in since March of 2009 may or may not end soon. History tells us, and we believe it, firmly, that bull markets die at the tail end of euphoric behavior, not skepticism, but be that as it may, this bull market will end when it will end. We do not believe it will be soon, but you just never know. However, the utterly uninformed refrain that "this bull market has gone on too long" does not stand up to the test of history. In fact, this bull market is just 50-75% the length of the four largest bull markets ever, and it is well less than half of the return of these prior bull markets. History is important here, maybe not for predictive value, but at least to avoid acting upon inaccurate premises.
Quote of the Week
"Human nature is a failed investor."
-- Nick Murray