President Trump's highly anticipated meeting with President Xi resulted in the best possible outcome any investor could have hoped for because finality and ultimate clarity were never actually on the table. But the brief talk went well enough that the additional tariffs on a new $300 billion of [largely consumer] products are not proceedings as President Trump had previously threatened. Reportedly, China agreed to large purchases of U.S. agricultural product while negotiations continue, and the Huawei ban has been temporarily lifted. It was by all practical definitions, a "cease fire" - but not yet a resolution. Prior tariffs continue, unfortunately, but no new tariffs are being imposed yet.
The investor takeaway should be rather obvious after the Buenos Aires meeting of last December - declarations of "progress" and "unity" are good, and better than the alternative (of escalating tariffs), but are obviously at risk of quick and unexpected reversal. For until a deal is done, and we really do not know what gaps still exist, the macro risk of uncertainty cannot be taken lightly. In fact, if one believes that the ultimate deal will only happen when pain reaches a point that forces one or both parties to get one done, you could argue that "truces" and "pauses" merely delay the pain that may prove necessary to create finality.
And how did the market respond?
Not surprisingly, the market opened up 250 points on Monday morning. And not surprisingly it closed the day up just 100 points. Tuesday at press time it was pretty darn flat. China's market rallied as well, and the Nikkei in Japan ripped higher.
Anything else need to be said?
There is not a trade deal between the U.S. and China at this time. There have been "pauses" before that ultimately did not lead to the resolution market participants are waiting for. Our view has been and continues to be that a deal will get done (that was our view even at the peak of the uncertainty back in May), but that the timing of finality is totally unknowable. It would be completely reckless to not assume that volatility is still very likely from this point forward as if anything the market expectation is even more vulnerable to headline risk and setback.
And get ready for this refrain, too: "Well, if the Fed was prepared to cut rates as insurance against the trade war, maybe this makes them less likely to cut now?" It is flawed because the Fed's recent talking up of a rate cut never had anything to do with the trade war. It was, and is, buyer's remorse over the last couple of rate hikes and what they did to credit markets (liquidity). Inflation expectations remain well below their target, and that will be the rationale when they go forward with a rate cut despite the trade war issues seemingly de-escalating.
2019 did what?
The first half of 2019 represented the strongest half of a year performance for the S&P 500 since 1997 (and by the way, adding to last year's theme of "all-time high phobia," feel free to note the 33% return of full-year 1997, the 28% return of 1998, and the 21% return of 1999). The month of June was the strongest June for the S&P since 1955 and the strongest June in the Dow since 1938.
The bond market has not been left out of the party, itself. The index advanced over 5.5% for the first six months of 2019, led by collapsing interest rates across the term structure.
The top-performing sectors in the S&P 500 were Technology, (+27%), Consumer Discretionary (+22%), and Industrials +21%). The worst performing sector was Health Care (still positive +8%) and Energy (+13%).
The Q4 2018 collapse was followed by a V-shaped recovery in Q1 2019. And then May's drop in 2019 was followed by a V-shaped recovery in June 2019.
Dividend Cafe - history, and philosophy
Dividend Income was 60% of the return of the stock market from the 1920’s all the way into the 1980s. The dividend payout ratio of U.S. stocks (the percentage of earnings companies out as dividends to their shareholders) averaged 90% before World War 2; it is less than 40% now. In Japan, it is barely 30%. In Europe, it is ~60%. However, with share buybacks, the percentage of capital returned to shareholders (dividends and share buybacks put together) does equal ~90%, but that number is heavily skewed by a few facts (namely, the level of share buybacks that are not actually a return of capital to shareholders but more offsetting shares issues via options and restricted shares in executive compensation).
As I go to great length to lay out in my book, share buybacks are not an affront against humanity or a substitute for proper management of a company. Share buybacks are a mode of returning cash to shareholders, and they have their place. Companies that want to have cash in the future do not “buy back shares when they should be investing in their own company” – they continue investing in their company (capex) so as to continue stewarding the company they have. The issue for us, though, is what makes for the best outcome for us as investors, in terms of what our own financial needs and goals are.
And in this, the record is abundantly clear. Investors receiving a continual flow of dividends, growing year by year, enjoy not only the mechanical accumulation benefit of compounding via reinvested dividends, but they enjoy the consistent, generous, and pragmatic benefits of growing cash flow (which can be spent). They reflect underlying companies who have higher quality businesses and business models, and this generally means a lower volatility experience in owning the companies.
In all thy getting, get this
The macro factors that drive the economy and even the stock market as a whole matter, and we allow them to inform the weightings we give to different asset classes in various client portfolio asset allocations. But as much attention as macro factors receive, nothing will ever be more important to an investor than the growth he or she is receiving in the dividends they receive from their investments. That focus ought to alleviate (in fact, eliminate) the tension one feels in the cycles of macroeconomic news. At the end of the day, we are invested in real companies at The Bahnsen Group, and those companies need to have business models that continue to perform even when the macro environment is not favorable. We want to invest in companies that continue growing the income you receive as a percentage of what you paid for the investment year over year over year over year.
The forces that create this economic reality - growing free cash flows leading to growing dividends for us - do not move at the speed of light, do not make headlines, and do not generate clicks. Can you imagine if the leading news headlines in financial media on a given day were: "Today, XYZ company saw all of its employees wake up, go to work, execute on a defensible business plan, ignore their market multiple, and deposit their daily revenues in the bank!" Execution, discipline, patience, avoidance of excessive debt, seasoned management, alignment with shareholders - well, let's just say these are not the things that web traffic and twitter followers are made of.
But they absolutely are the things investor success are made of. Follow the dividends. Look at a line of the annual dividend payments received from an investment from a point in time to a future point in time - and see what that line looks like. It is less noisy, and more telling.
And who does dividend growth work for, exactly?
Only two types of investors:
(1) Those who need/want cash flow now, and
(2) Those who will need/want cash flow later
In Emerging Markets, it's all about this ...
The currency risk in investing in Emerging Markets (though many EM investors from 1999-2007 would happily refer to it as the currency opportunity requires some sort of offset to make it all worthwhile. The geopolitical risk is no different, and perhaps more consistent (currency goes up and down; geopolitics is a constantly looming source of risk). So what is the rationale for the currency and geopolitical risk of investing in the emerging markets?
Earnings growth. Always and forever, earnings growth, tied to the secular theme of a growing middle class in the miracle of evolving free enterprise. This not an "either/or" predicament - you do not have to pick if you like earnings growth, or demographics ... The rationale for EM investing is the earnings growth made possible by the demographic realities. To apply a focus on net profit margins, high return on equity, and high return on invested capital to the opportunity set in emerging markets is where we believe the most optimal risk/reward profile exists.
We have not had a decade of disappointment in either the earnings story or the demographic story of emerging markets. We have just had a decade in which the currency realities cut into the price benefit of these stories for those denominated in U.S. dollar. This is unavoidable and unmistakably transitory. It does warrant a lower allocation to the space than we otherwise may be tempted to have. But where we can find high-quality growth at prices that support investor returns, we want to be invested. And from Telecom to the Banking sector, the emerging markets offer multiple opportunities of such.
The Death of Volatility
I do understand that many investors may think or even feel that equity volatility has been high, or that it is just plain always high. And indeed, every equity investor ought to always assume there will be elevated equity market volatility. But my job is to provide accurate information no matter how contrary it may be to various assumptions. The fact of the matter is that volatility has been brutally low since the acceleration in volatility last December, with a minor exception in the month of May. Generally speaking, 2019 has picked up where 2017 left off in terms of low market volatility (2018 sitting in the middle of those two years as a much more normal volatility year).
So what gives? What is the catalyst for suppressed volatility and what is the catalyst for elevated volatility? The answer is generally speaking - liquidity. Capital flows into the U.S. have been significant (global investors see the U.S. as the better place to be relative to the conditions they see in Europe and Asia). And of course, the Fed came into 2019 with a brand new outlook on liquidity - namely, that they would be a supplier of it, not a withdrawer of it.
Access to credit (especially cheap access) holds down default risk and covers up a lot of potential challenges in business operations. Low borrowing costs put a floor in corporate profits. Tight access to credit undermines projects and creates skittishness. And that is the essence of what creates volatility - skittishness (uncertainty). Volatility is not dead - but if it feels like it right now, it is because liquidity has been revived.
An outlook on the dollar
One thing I know to be much more impossible than other impossible feats like predicting stock prices, interest prices, and the direction of gold, is predicting the movement of the U.S. dollar. The shorter the time frame, the more impossible it is. But fundamentally, we do know that with the twin deficits the U.S. runs (a budget deficit that is through the roof, and a current account deficit that is ~5% of GDP), you generally should see a weaker currency, not a stronger one. Why has the U.S. dollar bucked this trend? Because we have attracted massive foreign capital to plug those deficits - period. How have we attracted such large amounts of foreign capital? The normal factors - rule of law, property rights, interest rate differentials, etc. Can this trend continue? Well sure, in theory. But in practice, the deficits have expanded despite strong economic growth. A hawkish Fed is now turning dovish. It becomes harder and harder to justify a strong dollar in this environment. A "flat/choppy" dollar has actually been the trend as of late, and that is with nothing good to say about Euro or Yen for some time.
Is so much of this liquidity-driven?
An astute reader asked me last week if so much of the support for risk asset prices was simply a matter of the revamped liquidity found in capital markets this year. And the answer to that question is, "of course!" But the problem with the question is the two words "this year" - which makes it sound like this is a transitory thing. Additional liquidity into capital markets drives prices, always and forever, and a contraction of liquidity compresses prices, always and forever. This is not temporal - it is the nature of the credit-based capital markets in which we live in an era of central banking. One can like it, one can hate it, and one can believe it depends on the rules in which it is administered (yours truly); but one can not and should not deny it. The valuations that set asset prices are heavily correlated to liquidity levels in capital markets, and always will be.
Politics & Money: Beltway Bulls and Bears
- We have already covered the China/trade developments, and I am really not sure that the President's step into the DMZ of North Korea constitutes a market event (and you don't want to know what I personally think about it). But there is another market event potentially floating around in the political world, and it is one we have discussed before but thought it may have died. Multiple news outlets are reporting that the White House is, indeed, preparing a revision to capital gain taxation policy that would allow for the indexing of inflation in calculating the actual gain. The only reason I can think of for the media's ignoring of this story is that they realize it would likely be so widely approved by the public if it were to receive a public airing that it would create additional momentum for the completely logical and reasonable policy idea. It would surely face a legal challenge if the Treasury Department were to issue such a policy ruling, but it would be a highly productive pro-growth mechanism for capital formation. We are waiting with bated breath.
- What would the indexing of capital gains to inflation do (besides creating more fairness and equity in the tax code by not taxing people on gains they did not really achieve)? By reducing the nominal tax impact of selling an investment, it creates an "unlocking" effect where assets that would otherwise be held become more probable candidates for sale, allowing for more replacement of capital with more opportunistic uses. It boosts the value of the underlying assets (because it's real, after-tax value is now mathematically higher in the most literal of senses). And from a supply-side standpoint, it incentives new business, new projects, new growth opportunities because it adds to the incentive for doing so.
Chart of the Week
It is interesting that we talk so much about equity P/E ratios, and I certainly agree that historical valuations matter, but spend so little time talking about other valuations. Since I believe (well, actually, I know) that all assets are worth some multiple of the cash they generate (and will generate), it is quite easy to look at present valuations in widely held asset classes like Bonds and Real Estate as well. And if historical valuations vs. present "cash multiples" are what matter, stocks look positively cheap.
(Note - I will pre-emptively concede, the "historical valuations" become relative when the Fed is driving the ship.)
Quote of the Week
“The sign of a true gentleman: He treats adversity with the same grace he treats success.”
-- Reinaldo Herrera
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I do want to wish everyone a very Happy Fourth of July. It is one of the most conflicting holidays of the year for me, in that I absolutely love it, absolutely cherish the country's founding, and believe from the bottom of my heart in a national day to celebrate our independence and the principles on which the American experiment began. And yet, I can't ever shake my dissatisfaction with how many people just treat it as a generic "off day" - a mere fun occasion - some form of vacation day devoid of any reflection on the aforementioned realities.
The birth of America and the fertile environment our Declaration of Independence gives to the aspirational society are not irrelevant topics to investors. The inalienable rights laid out in our founding document, and the entire concept of the "pursuit of happiness," provided the very DNA that we are invested into this day - free enterprise, the pursuit of a better life, the framework by which great businesses can be created and great innovations achieved.
At the end of the day, the investible universe all comes down to the pursuit of happiness. Even if one actually parked all their money in a bank savings account, the interest is only generated because the banks make a spread by lending out customer deposits to those doing profit-seeking endeavors with the money. All "investment returns" - the interest paid by bonds, the profits earned from stocks, and even rental income from real estate (there is no rent money without a profitable endeavor inside the office, warehouse, store, etc.) - are a by-product of the free and open marketplace, protected by a government created by the people. The Declaration was a profound statement of an entirely new way of thinking about the human person (that he/she was endowed by their Creator), about the relationship to government, and about the formation of a civil society.
Today we not only invest in a world made possible by the world-changing events of 1776, but we enjoy a political and religious freedom that the world has simply never seen prior to that great day. I do wish everyone a day of BBQ, picnics, the beach, fun, and rest tomorrow. But I just wish that all who live out the day to those ends appreciate that what they are enjoying are fruits of a freedom tree planted in the soil of ideas - and those ideas changed the world forever, on July 4, 1776.