Because of my meeting schedule Thursday and Friday of this week and travel west on Wednesday afternoon, I submitted this week's Dividend Café Wednesday morning, which these days is always a little tricky, as it allows for three days of market action to make obsolete something I said. Of course, other than those few "ad hoc" news-sensitive items, the least important parts of this weekly communique, nothing should ever be made "obsolete" in three days time. That said, if anything you read herein feels out of date, well, then I did something wrong.
I do believe this week's Dividend Café is particularly useful for finding a true summary of the state of markets - for being able to actually reduce the tension an investor faces to one key dynamic. So jump into the Café and find that out, along with plenty more about the market, the economy, the dollar, and all the stuff that moves us, whether it be Wednesday, Friday, or any other day!
Forgiveness in advance as we repeat the most important thing
I am asking for forgiveness in advance as I believe this will be a theme you will see repeated in our various mediums ad nauseam in the weeks and months ahead. Perhaps I should ask for forgiveness retroactively as well, because I am quite sure it has already been covered up to this point. But it bears repeating, and has significant implications for how investors think about the present market dynamic.
The forces pulling the market right now are neither bullish nor bearish; rather, they are both. The market has been in a very sideways trend, for what feels like a while (we actually don't believe 3-4 months is that long, but we understand why it feels like it). The sideways trend will not last forever, but timing what breaks it to the next level, and why, is nearly impossible to do. The "both" can be summarized in these ways:
Bullish - Macroeconomic forces in the U.S. are dynamically good, with low unemployment, growing GDP, growing manufacturing, rising business investment, increased productivity, and positive business and corporate sentiment. Company earnings continue to grow. The economy is healthy.
And that "push" force is up against the "pull" force of ...
Bearish - A flattening yield curve coming from Fed tightening in the short end of the curve, feeding concerns around inflation and interest rates and overall monetary policy dampening of the very bullish factors which preceded this.
Call it a tug-o'-war ... The bullish forces are real but exist right now in a market context of skittish volatility, largely driven by the uncertainty of a new monetary regime. Are geopolitical factors adding to the "wall of worry" (i.e. trade/tariff concerns, Europe/Italy, etc.)? Sure, they play in - especially if the trade side were to worsen unexpectedly. But more or less what investors need to understand is that there are two competing forces at play in the market right now - a healthy economy and corporate earnings environment, vs. a vulnerable yield curve and monetary policy landscape - and no investor on God's green earth can state how it will play out, or when.
For our money (and yours), the right play is always and forever to invest in fundamentals. Earnings growth and economic growth are real, and we believe stand to win this game of poker (how many analogies and clichés will I be able to pour into this one section, you ask). But that reality requires the patience, discipline, and understanding that "noise" is tough to overcome in the short term, even though the rewards are great for those who do.
Makes sense. Now. How strong is the economy?
Could the second quarter GDP reading come in at +4%? It certainly could (this would be huge). We talk about the unemployment side and manufacturing side of the present economy in the Politics and Money section below. GDP growth is the by-product of a lot of factors, not just manufacturing and jobs, for example. But frankly, it is hard to find a metric that points to some negative detractor as likely in our analysis of the big picture economy. As we go to great lengths to state in the preceding section, this economic strength is not sufficient to tell us what the next leg of market returns will be, but it certainly sets a different conversation than one where we discerning how the market would perform in a very challenged or questionable economy.
Investing for all seasons
The fear of the flat yield curve, rising interest rates, inflationary, tight monetary policy school of thought, comes from the belief that massive budget deficits will need to be funded through tighter monetary policy, and that normalization of our balance sheet and short-term rates (to restore policy tools) will prolong a "risk off" environment in the capital markets. In this school of thought, we would expect lower beta, more value-oriented names, dividend-growth names, to relatively perform quite well. We would not expect financials and high P/E stocks to do well. On the other hand, should significant foreign capital work its way into the U.S., it diminishes the need for the Fed to normalize and tighten. We see emerging markets as a winner in any scenario where the Fed normalization fear ends up underwhelming those concerned about it.
So bottom line - making a call on how those things will play out strikes us as foolhardy and dangerous. Being invested for both outcomes diminishes upside, sure, but it also significantly diminishes downside.
Technically speaking, technical analysis doesn't predict anything
I have spent most of the last 20 years lambasting the idea that looking at a chart tells you what an investment is about to do, as opposed to what it just got done doing. The predictive value of "charting" and "technical analysis" is not held in high regard at The Bahnsen Group, and we have ample empirical support for our position. And amongst the most frivolous of tenets held by advocates of this technique is the alleged doom that an asset dropping below its "200-day moving average" represents. We hear it all the time - the "200-day average" is held out as a pivotally important data point in forecasting what the market index may do next. Well, it isn't good for any such thing, and our theory that the reason it gets used in such analysis is that "any idiot can do it" remains our working theory. Note how the S&P performed immediately following the last two times it "broke below its 200-day moving average."
Shock of the week
The U.S. dollar's exchange rate with Europe is currently around $1.17. This is essentially the same as it was late last year. The Euro had rallied against the dollar hard to start the year, and that did reverse in April, but it has essentially moved higher, not lower, against the dollar in the last week or two despite the situation in Italy.
Despite the rally the dollar enjoyed in April, we cannot say that the Euro should have held up even this well when we look at the factors supposedly at play (Italy disruption, Fed normalization vs. ECB continued stimulus, etc.). Yes, the dollar has rallied, but frankly, the Euro's stubborn "holding on" vs. the dollar strongly indicates that how this will unfold in the weeks or months ahead is not likely to be according to the media's script. What I am saying is this - not all of the facts are lining up.
A profitable mystery
We know that profits were up 23% in the first quarter vs. the prior quarter, and up 14% year-over-year. The significant impact of tax reform in adding to profits by reducing tax liability cannot be overstated. But what strikes me as bizarre, is that no one is talking about the pre-tax profit growth of 4.3% (year-over-year, for the quarter). That is a significant number, non-attributable to the impact of tax reform.
The issue for markets is not whether or not profit growth is real; it is real, and it is likely to continue. And earnings are, forever and ever, the mother's milk of stock investing. The issue, though, is when the growth of those profits will slow in the face of higher costs (wages, materials, debt service, and currency impact). Those factors, as they are prone to do in a growing economy, will eventually limit growth-of-profits, regardless of how healthy organic revenue growth is. That could be a ways off, but it is a far more formidable reality than trying to down-talk the real profit story we are experiencing now.
When it comes to the oil and gas pipelines we are so bullish about long term, the 14%+ return so far this quarter has not remotely dampened the enthusiasm for our thesis. Yes, this performance has been long overdue and is encouraging, but it does not come close to putting the space at fair value (not by any metric we utilize to assess such). The wide differentials of what crude is having to sell for in the Permian basin has brought national attention to the impact on producers when they lack pipeline capacity to ship their profitably produced oil. The yield spreads remain very, very high, offering attractive current income and continued growth of that income via annual distribution increases. My belief is that so much of the turmoil in the space over the last three years will be the catalyst to the next growth phase as these realities get better understood and actionable throughout capital markets. For out of this turmoil, operators have had to decrease leverage, optimize distribution habits, improve management, rationalize projects, and generally become more diligent and prudent economic actors. Is this story "free money"? Of course not - a premium in return carries risk. But do we believe we are in early innings of what will transpire for oil and gas pipelines? Yes, we do.
Politics and Money: The Beltway Bull and Bear
Get a job in May and the President has much to say
The 223,000 jobs number in May was a big surprise, roughly 50,000 above expectations, and accompanied by a goldilocks wage growth number of +2.7%. There were also 15,000 revisions to the upside for the last two months. A 3.75% unemployment number is something to behold. Increases came in retail, services, manufacturing, healthcare, and construction. The collapsing labor participation rate appears to have stabilized as well, and mostly flat-lined for a little while now.
The healthy job market likely has a lot to do with the increase in the President's approval rating.
Contrarianism comes to Washington
Is it possible that the negative fear in markets which are specifically politically-driven are, in fact, now opportunities? Let me walk you through this. What are legitimate market concerns that have their genesis in the beltway? I am sorry, but the often bizarre use of Twitter by the President may generate an emotive response from a portion of the citizenry, but Mr. Market long ago began blocking that particular twitter user. What Mr. Market does care about, though, is trade policy. And proposed regulation on technology companies. And deficits. What we would see as a significant possibility is that the "political risk" embedded in these things has been well-priced by markets, are "known knowns" (to borrow from Secretary Rumsfeld), and may represent a contrarian catalyst to upward movement if some or all of these aspects prove less troublesome than has been priced.
Manufacturing resurgence speaks to capex, and midterms?
Will a U.S. surge in manufacturing matter for the midterms? For 2020? We wouldn't be surprised. And if capex is just getting warmed up, this may be early innings.
Chart of the Week
Yes, there are plenty of reasons to consider market volatility, to embrace market volatility, to sweat market volatility, and to generally discuss market volatility. What there are not reasons to do is actually act on market volatility when it comes to one's investment discipline. The declining red line in this week's Chart of the Week reflects the retail investor's outflows from equities over the last ten years, surely driven by the flood of headlines surrounding such actions. The blue shading reflects the price performance of the stock market. The relationship between the two seems rather clear.
Quote of the Week
“There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class. There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time. Not many can always have adequate reasons for buying and selling stocks daily – or sufficient knowledge to make his play an intelligent play.”
-- Jesse Livermore
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I spoke in an earlier section of the need for patience, discipline, and filtering of noise to properly navigate the interesting market environment in which we find ourselves. We have been used to periods of "risk on" vs. "risk off" for many years now (nine years, to be precise), and directionlessness has been non-existent. That burden does not primarily lie with our clients. Indeed, patience, discipline, and the filtering of noise is our job. It is to that end, we work. And it is to that end that we focus our energies - intensely so - as we enter the summer of 2018.