At press time markets were up a bit on the week, but nothing constructive after last week's downside, and "at press time" could be ancient history by the time you are reading this. Interestingly, this week would appear to be quite non-volatile as the up and down movements day by day look to be really small (up 30, down 50, up 150). However, the intra-day movement has been positively surreal, moving up 600 points or so Monday from an intra-day low, and down 400 Tuesday from an intra-day high, etc.). So even if you don't see it in one-day stretches, the one-hour intervals and one-minute intervals remain action-packed.
It is a testimony to the folly of this media and digital age that we are talking about one minute, one hour, one day, one week, and for that matter, one month, periods - as it pertains to capital that has 10-year, 20-year, and 40-year timelines in their objectives. And yet, here we are. The short-termism of the culture is powerful and had no reason to be limited in its touch so as to not affect investors.
This week's Dividend Café will address our approach to such things, which of course we believe is the right approach. We will unpack the problems in business confidence, and the solutions to those problems. We will look at the length of time dislocations might last. We will look at Europe, at the trade war, at Brexit, at politics and the Mueller investigation, and at so much more. Come look at all of this with us, inside the Dividend Café.
God grant me the serenity
The famous prayer calls for the ability - the wisdom - to know what can be changed (controlled?) and that which cannot. It has been my thesis for many years that there are effectively three major categories of the way investment managers tackle markets:
(1) To close their eyes and view all aspects of that which affects their client holdings as unmanageable and uncontrollable, therefore calling for a completely passive and hopeful approach … This may be considered a sort of "extreme passive" approach.
(2) To believe (hope against hope) in defiance of the experience and exhortation of the smartest investors in world history that all aspects can be foreseen, known, avoided, predicted, anticipated, and acted upon. P/E ratios are about to contract? No problem - this person will know. Geopolitics about to intervene in market sentiment for one week? This cat will get in front of it. Central banks about to relax monetary tightening? This guy knew the day before. Etc. Etc. In other words, this approach seeks to not just monitor what is effectively manageable, but that which is most definitely not manageable, knowable, or controllable, either.
(3) To focus one's active management on the limited scope of what can be researched, is evidence-based, and fits within the framework of "risk/reward" calculations. This is a more humble approach than option 2, and it is a more industrious approach than option 3. It also happens to be the heart of our philosophy at The Bahnsen Group. So managing and monitoring free cash flow growth, dividend payout policies, capital allocation on the balance sheet, the nuances of a company's income statement, the culture of a company, the alignment of management with shareholders, the cyclicality of an earning stream, etc. - these things are reasonably manageable if one is willing to invest the time and effort into such a process.
It is the laziness of option 1 and the arrogance of option 2 (not to mention the futility of it) that cause us to reject those two options. Those who experience temporal success in option 2 fall prey over and over and over again to the most dangerous investment trap on the planet - being fooled by false noise - being fooled by randomness - mistaking happenstance for repeatable skill. It is systemic.
Even in option 3, the focus on that which we believe can be studied (dividend growth, as an example) vs. what cannot be known (the direction of P/E ratios, for example), also requires what I might call a "constrained vision" of investing - meaning, the hope or belief that it even can be done perfectly or without error is tragic and wholly unnecessary. Risk management can avert the problems that arise out of analytical mistakes. The free gift of diversification and asset allocation goes a long way there.
A constrained vision combined with a focus on that which can be managed intelligently makes for a much higher serenity in the investing process and investing outcomes than any alternative I have ever seen.
Speaking of P/E ratios ...
Interestingly, the bears loved to appeal to the "high P/E ratio of the S&P 500" in 2016-2017 to make their case for stocks going down (as stocks went from 16,000 to 26,000, by the way - you know, a little 62% gain from trough to peak in two years). But an interesting thing has happened for those people who got their faces ripped off than with their pathological permanent bearishness - the forward multiple of global equities is now the lowest it has been in five years!!! The combination of lower global equity prices bringing the multiple down and earnings themselves substantially rising has made for a P/E ratio at multi-year lows. Has this caused the valuation-fearful bears to change their tune? Of course not. Perma-bearishness is a pseudo-intellectual sociological deficiency and not a rationally-driven exercise in analysis or objectivity.
It's all about business confidence
The connecting of the dots from how this post-crisis economic recovery needs enhanced profits to drive markets higher, and enhanced profits need greater productivity in the face of higher input costs, and how higher productivity needs increased business investment via capital expenditures, and how higher capex must come from greater business confidence, and how an undermining of business confidence (due to the trade war) has been at the heart of this market sell-off, is all laid out in this piece I wrote at our Market Epicurean property this week. I also created a special podcast on the subject as well. I reiterate for Dividend Café readers, as business confidence goes in this phase of the cycle, so goes the market.
A diatribe on dislocations
How does one know if a market correction is a dislocation or a secular reversal in markets? Of the 60+ times markets have experienced a 5%+ dislocation over the last nine years (as markets advanced 300%), how did we know each time it was a temporal dislocation and not a lasting reversal? Let me say this - can you imagine someone in my shoes saying that they did know when dislocations were happening how long they were going to last? Heaven help us. The answer is that embedded in the risk premium of markets is that you do not know how long dislocations last. What we have to do as market fundamentalists when such dislocations take place is look at the causation, and determine how much of price movement is sentiment-driven relative to fundamentals in the causation. We have to evaluate how transitory the catalysts of dislocation may be. And we have to do risk/reward calculations. Period.
Now, with that said, there are clear potentially transitory catalysts in the recent market sell-off (i.e. trade uncertainty that may very well get better, soon). However, that potential for a longer period of trade-induced distress is real, and the uncertainty around the current state of affairs is presently real, not merely potential. So I feel very comfortable calling this current distress a dislocation (a self-induced one, I may add), but I also feel very comfortable advising my clients to stay prudent and judicious vs. reactive and rash.
In all thy remembering, remember this
Good investors have an investment policy that drives their investment practices, otherwise, they are winging it. We have a custom investment policy written for every single individual client of ours (did you know that?). And that policy reflects a target or bandwidth of comfort around downside volatility. That targeted downside is not meant to be theoretical; it is a real number of real comfort around potentially real volatility. So when markets decline a fraction of that downside tolerance figure, they have not violated an investor's strategy - they are very much within the strategy - with room to go.
To that end, we work.
Deeper jobs report dive
The November number was expected to be closer to 200,000, and it came through at 155,000, but the unemployment rate stayed at 3.7%, and we have seen for some time now the need to "roll" quarterly averages to properly evaluate the jobs data (to smooth for monthly lumpiness in the data).
What trade war?
The trade deficit increased to $55.5 billion in October, a number that does impact GDP in the sense that GDP reflects (exports-imports) in its formula … However, the total gross amount of trade was higher, which was quite encouraging to me (I have written about and spoken about trade deficits quite a bit in the past, and fundamentally know them to be neither good nor bad, in and of themselves). The key, though, was that what drove the numbers this month was a collapse in the U.S. exports of soybeans in particular (it made up almost the entire delta between the actual number and the consensus expectation). Our agricultural industry is taking it on the chin in this self-induced trade war, and it also is a key area set to improve if the talks with the U.S. and China go as hoped.
What would make the good people of Western Europe feel that the European currency has been a failed experiment, or that the rewards have been disproportionately in Germany's favor vs. other countries? Perhaps this chart reflecting industrial production since the advent of the Euro tells the story.
I am not sure that we can appreciate the level of hostility that is building up and has built up in pockets of the European continent around this reality. Italian bond spreads over German bunds or French debt both point to a tail-risk of Italy leaving the European Union at some point, but in reality, the lack of organic economic growth combined with excessive sovereign indebtedness represents a continent-wide problem, not merely an Italian one. The French social unrest in recent weeks does not point to a desire for higher taxes or more government spending - it points to the fact that France is the most heavily taxed country on earth, yet one of the lowest per capita spenders in education, health care, or national security. That is not a good milieu for keeping the support of the people. The cultural and economic backdrop continues to call for significant underweight to European exposure.
And what about Britain?
It's harder to write about the UK/Brexit discussions this week because of the near inevitability that by the time I finish typing a paragraph there will be new news. Prime Minister Theresa May barely survived an attempt to strip her of power, and the parliamentary vote on Brexit particulars remains pending. Support for the present version of that Brexit procedure is inadequate for passage, and yet deadlines linger that could lead to a hard Brexit / total EU rupture. It remains my view (with absolutely no equivocation or trepidation) that the real risk is merely in the various uncertainty-induced volatilities along the way that this process will create, but that ultimately neither a non-Brexit or a brutal Brexit are real scenarios.
The amount of global economic conditions right now contingent on "negotiations" is somewhat surreal, and a totally legitimate explanation of elevated volatility (here and abroad).
Politics & Money: Beltway Bulls and Bears
- It seems fairer than it has been in the past to wonder if the various headline events around Michael Cohen, Paul Manafort, Michael Flynn, Robert Mueller, SDNY, etc. are beginning to impact markets. It has been our position for over a year and a half now (clearly reinforced by market action) that the various dramas around the special counsel and such received a shrug from markets, with their attention far more on tax reform, corporate profits, the Fed, and the trade war. Nothing is going on now that changes that prioritization - the markets will never have the same priorities that the Beltway does (much like Main Street will never have the same priorities as the Beltway). But that said, should some of the legal circus escalate to a certain point for the President, it is entirely possible it will elevate the volatility levels of the market. Now, that is different than expecting the market to respond to any little movement around societal clowns like Michael Cohen or Michael Avenatti … But to the extent any substantive levels pick up, beyond noise, the vulnerability of the market right now is susceptible to any number of volatility catalysts.
- If you asked me to rate what political events matter to the market right now, I would say it is 20 parts trade war and 1 part special counsel. And as far as that ratio goes, I actually may be understating the relevance of the trade war and overstating the legal drama.
- I frequently air my distaste for media-manufactured drama in financial markets, and this week I think we got a healthy dose of it in the aftermath of the rather surreal argument between President Trump and Speaker Pelosi/Senator Schumer that aired on national television. Certain pundits who shall remain nameless took to the air to suggest that markets (which were actually unchanged) were responding to the awful underbelly of the political process at work (as if markets were previously unaware that the two sides do not get along very well). I try my best to take seriously every potential disruptor to U.S. market stability, but if there is any political event that is exhausting in the boredom it produces in markets time after time after time it is the "budget showdown" debate and the "government shutdown" debate. I am perfectly content to admit how much dysfunction these kinds of things illuminate in the management of our national government, but the idea that these things are fundamentally market disruptive when (a) Everyone knows they end up re-opening government five minutes later every time; and (b) Almost all of government is funded for all of next year anyway, so this is practically entirely cosmetic, is absurd.
Chart of the Week
A "yield curve inversion" for our purposes centers around the spread between 2-year Treasuries and 10-year Treasuries and refers to yields being lower for the 10-year than the 2-year (an inversion of what is normal, logical, and healthy - and can only happen when policy and conditions are distorted). This inversion has not yet happened in this cycle, though the spread has flattened to its lowest levels in over a decade. But the historical potential for a sustained period of a "flat" curve notwithstanding, the average time from an inversion to a recession onset is really unpredictable, making those using this conversation as a tool to time the market beyond foolish.
Quote of the Week
"The stock market is the only place where the customers don't buy when the merchandise goes on sale."
-- Alex Green