Greetings from New York City where I actually spent a day in Connecticut this week with clients and another day in Boston with clients and investment banks. I am en route back to California as this is being delivered to you, where I will immediately experience a 50-degree bump in weather from departure city to arrival city.
Markets had no such weather volatility this week as things were reasonably tame yet again (at least as of press time). This has thus far been a very flat week in markets both from start to finish but also intra-day as well. I think the reason for that is examined in a clear and understandable way in this week's Dividend Cafe.
But I strive to do a lot more in the Dividend Cafe this week than just look at the week that was in markets ... We look at the full scope of the China trade status, going into 2020, we look at the cash on the sidelines of the American economy, and we look at where growth can be expected to be for years to come (this is my favorite section of the Dividend Cafe this week!). I even offer a periodic reminder on the realities of gold investing, and of course, offer the normal mix of politics and money. Click on in, check it out, and welcome to the Dividend Cafe!
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Why the optimism?
Why is the market feeling good about this U.S.-China trade deal versus the others that broke down (for that matter, why do I feel different about this one versus the others)? Because the scope of this "phase one" deal is narrow and not caught up with the larger issues that are more complex and more susceptible to breakdown. Ultimately, pledges to "reduce the trade deficit" (i.e. China agrees to buy more from the U.S.) was never, ever, ever a problem. China was always willing to buy more agricultural products and energy products from us because - guess what - they need such from us! Some additional currency guardrails help beef up phase one, and the complications of intellectual property will get dealt with later.
The advantage to this current structural direction is neither side is being humiliated, and ultimately, someone will have to look like a net-giver (net "loser" as some may say). That time is not yet, and if it were, phase one would not be happening. Phase one is not that ambitious, which is why it is getting done. But there is more work ahead on technology, supply chain, IP, and security. We know this.
I have been as clear as can be what I believe about tariffs and how the risks they have posed to U.S. economic growth ever since the trade war began. I remain of the same convictions I have had on these issues for many years, and I believe that the entire discussion of "trade deficits" polluted the needed policy progress the administration has sought. That said, I will not at all be surprised to see this turn into a political success story for the President from a messaging standpoint in the weeks or months to come, if it does play out as I am forecasting. I believe we will be wise to view this primarily through a political lens and not an economic one until proven wrong.
This week's contrarian indicator
$3.5 trillion sits in money market funds around the country, nearing the levels we saw at the bottom of the financial crisis. This is simply stunning that this much money sits in cash even as markets are making new highs.
However, as a percentage of the total S&P 500 market cap, cash is not particularly abnormal (not too high or too low). Ultimately, the idea of large cash levels coming off the sidelines into the market is a "melt-up" risk to the market.
Remember earnings, everyone?
With pretty much the whole S&P 500 having reported Q3 results (there are still a few stragglers, but close enough), 75% of companies beat their earnings estimates. The market rewarded earnings beats more than normal this quarter; in fact, it was the largest post-release move higher in stock prices for earnings success stories in over five years. The net-net results of it all are that it was a good quarter relative to expectations, and particularly good for select high-quality names. Some lower quality tech names didn't support the earnings level of the market much, but all in all, it was a good quarter - not great, but not reflective of the level of earnings slowdown many were expecting.
Economic check-in on aisle one
The Small Business Optimism Survey rose a bit in October but remains well below its summer 2017 (read - pre-trade war) levels. Capital spending improved with a tick-up in equipment, vehicles, and facilities. But 40% of owners did report a negative impact from the trade war, a big move higher from the 30% the month prior. Small businesses continue to struggle to find good labor which is both a negative (for companies, who then may experience a stall in productivity growth) and a positive (for workers, who have leverage, opportunity, and growing wages).
On Golden Pond
I have gotten several inquiries as to whether or not Gold’s recent sell-off is a reflection of better news and sentiment in the economy. Down over $100/ounce (-6%) since Labor Day, it’s a fine assumption that gold may be a counter-cyclical trade to risk-on. However, the mistake is in assuming gold needs a reason to go down, which is the other side of the coin of the same mistake that believes gold needs a reason to go up … In reality, gold goes up and gold goes down for reasons entirely disconnected from fundamentals or discernible macro reasons.
The two biggest fallacies that exist about investing in gold are that: (a) It is an inflation hedge, and (b) It is a trade against the U.S. dollar. From 2004-2014 the dollar really didn’t move, but gold tripled. And from 1980-current inflation has dramatically outperformed gold (by more than double). So both theses are wrong, empirically. Longer-term trends are undetectable.
I have been writing this for many years now and want to reiterate it now as much as ever: Whenever people own something for the wrong reasons, it is susceptible to incredibly erratic price action. There are plenty of reasons to own gold or not own gold, but too many people own it for reasons that “just ain’t so …” That makes it inherently unpredictable.
Truly Emerging for a Long Time
It has been quite some time now that I have been convinced that real “growth” investing had more attractive opportunities in the so-called emerging markets of the globe than the U.S. – that the opportunity to buy companies with serious growth acceleration in front of them without significant “paying up” for such was far more plentiful in these emerging markets. The headwinds were (and are) currency and geopolitical risk, but the belief that domestic, local business growth was incredibly investible for many companies in various developing parts of the world became a huge part of our worldview.
I am as convinced of the thesis now as ever, and more disciplined, patient, and informed about it. Transitory issues do not impact my thinking the way they used to, and the right long-term perspective informs us continuously. That said, investors are wise to ask where they believe the right growth opportunities lie tactically, especially if they believe (as we do) that the so-called FANG trade is long past us. We see the Brexit concerns and trade war fears largely tamed (but not eliminated), and we certainly see a Federal Reserve that has changed the monetary landscape concerns. Dollar strength seems likely to reverse, and fiscal reforms, regulatory improvements, and monetary stimulus are easy to find around the emerging world.
One of my favorite economists, Louis Gave, recently pointed out that cutting rates in Europe or America has very little impact due to how low rates already are and how mature economic consumption and production behaviors already are, whereas in emerging markets reduced rates are far more impactful for their stimulative effect in consumption, capex, and risk-taking. I see no evidence that the opportunity in emerging markets (especially ex-China) has been priced in, and this continues to be a generational story in our view.
Can Growth be Good Here?
American productivity, enterprise, and entrepreneurial innovation is the envy of the world, and I do not see that changing any time soon (please, God). But two things have to be said about this … One is that already-very-successful growth-oriented companies have that very well-priced into their stock price reality, meaning many investors are investing in them only for a higher-still multiple, not the growth itself. This turns into a greater-fool theory over time. The other is that hyper-indebtedness is deflationary, compresses expected returns on new projects, and favors existing assets over potential new ones. This is called anti-growth. Reduced investment in new “stuff” limits the opportunity for growth investors. Long-term, depressed interest rates damage the structural growth rate of our economy, period. Risk assets can benefit in the here and now (and they have, and they do), but for those looking out ten years who want U.S. growth to remain the innovative leadership envy of the world, root for natural interest rates, not what we have now.
What is the opposite of a silver lining?
It has been a great quarter for dividend growth equities in terms of this earnings season, yet one negative standout has been in the MLP/energy pipeline space. The total return in the sector remains positive on the year, but barely, and the space started the year with a bang, not a whimper. Why has midstream energy been the opposite of a silver lining lately? The space certainly feels quite oversold since July, and there are technical reasons to believe it is likely to trade better in short order. The fundamentals holding prices down are all long-term positive but short-term problematic: Producer discipline on supply; pipeline operator discipline on capex and on capital management. The space has consolidated a bit since 2015, but not enough. Less weak operators with more strong operators who possess pricing power would be a game-changer for the sector.
Bottom line on China/trade deal
Borrowing from my dear friend, Rene Aninao:
"Bottom Line: still a very high likelihood that a Phase I deal with China, which includes a pathway towards significant tariff relief, is signed on US soil before Dec 15th—with Phase II signed sometime in late Q1 / early Q2 [after Super Tuesday, once Beijing can better assess if the Democrat nominee is indeed Warren or Biden-Buttigieg]."
Politics & Money: Beltway Bulls and Bears
- The idea that Michael Bloomberg may enter the Democratic primary is interesting but tough to handicap. His odds of winning the primary are far, far lower than his odds of winning the general election. I do believe the Mayor is putting himself on state ballots "just in case" Biden collapses in Iowa (which is not out of the question, but not assured). I am surprised anyone would be looking at polling around Bloomberg in the primary as if comparing a candidate who has not been in the race to candidates campaigning, spending money, doing nationally televised debates, etc. is any kind of comparison. Biden does appear to be in trouble (directionally), but stable (base support). Honestly, this Democratic primary is wide open and there are so many ways it can still play out.
- Just as I find it absurd to make an investment policy right now out of Elizabeth Warren winning, I find it even more absurd to do the same around someone (Bloomberg) not even in the race-winning. Bloomberg does support private health insurance, opposes the green new deal atrocity, and is a known free trader. Of course, someone who made $53 billion selling market systems and intelligence to Wall Street is not likely to be an anti-financial markets candidate. However, he is a liberal independent and will be hard to put in a box ideologically. Again, my own view is that he would be very tough to beat in a general election (with his lack of support from far-left progressives opposed to his incredible wealth being more than offset by independents and moderate Republicans who would migrate his way). However, it really is hard at this time to see how the stars align in his favor for the Democratic primary. For now, I think he has "hedged" against a Biden collapse by putting himself on some ballots, as he sees a far-left progressive like Warren or Sanders as unelectable. So many moving parts!
- Speaking of far-left progressive, Warren: Her odds of winning the Democratic nomination were 25% in mid-August, and rose to 50% in mid-October. They have since fallen to about 30%, largely in response to her Medicare-for-All debacle at the last debate (unable and unwilling to answer how she would pay for it, with the implication being that yet more tax increases were coming). Betting odds are not hard science, but they sometimes can be more reliable than polls.
Chart of the Week
There will be more and more discussion of "valuation" as equity prices continue ascending, and when it comes to entry-level investing and long-term expected returns, valuations matter! The chart below shows whereby some metrics the market is fairly valued (meaning, by average historical valuation metrics), in others, it is a tad frothy, and in some cases, it is even a tad light. Perhaps the most important metric in the here and now is the Fed model, whereby the earnings are compared to the treasury yield. The bottom line is that low-interest rates distort valuation metrics, and that valuation is not useful for timing. But in the macro, we want to stay attuned to valuations and relative opportunities. To that end, we work.
Quote of the Week
"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen."
-- Frederic Bastiat