Dividend Café

Actively Clarifying What Has Passively Become Silly - Sept. 7, 2018


Dear Valued Clients and Friends,

It was a short week in the markets due to the Monday holiday, but the prime is being pumped for an action-packed end to the year.  One part of our trip to the Dividend Café this week explores just how challenging of a year it has actually been in capital markets this year, with essentially 9 out of 10 major asset classes in negative territory for the year (but the one asset class everybody talks about the most being the one positive).  This week’s commentary spends a fair time hashing out what it means to be “passively” invested versus “active,” and why the questions are far more problematic than the answers.  Across the board, there is a lot to read this week …

So we cover a lot this week, and I believe you will feel very happy this week with what you find in the Dividend Café.

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Putting the Passive Debate to Pasture

I am not sure there has ever been a bigger debate in the asset management industry than the one of “passive investing” vs. “active investing” – of the notion made famous by Jack Bogle (founder of Vanguard) that buying market indices is the most prudent way to invest because they can be obtained for a lower cost than active strategies, and active managers can not or do not beat the market anyway … It is a fascinating debate intellectually, but also methodologically. Most actors in the debate have some ax to grind, and it should be no surprise that this gets reflected in the debate itself. But that said, I want to dedicate some significant space to the topic this week.

I will defend passive once you prove it exists

2018 presents a fascinating opportunity to present the main argument I would make, which is essentially that there is no such thing as passive investing. We are supposed to believe that some broad market index captures the need investors have for stock market exposure, and that is fine – but what index? Do we pick the S&P 500 for U.S. exposure, and then a European index for international exposure? Or do we skip exposure outside the U.S. altogether? See, once that question alone is answered, someone became an “active manager.” The S&P 500 with no European or Japanese or emerging markets index accompanying it will outperform a global market index in a year like 2018 but will underperform in many, many years. What if we just buy a “world” market index? Now we have passive stock exposure all over the world. And of course, that European, Japanese, and emerging exposure can either cause it to substantially under-perform or out-perform an all-U.S. equity index like the S&P 500 (case in point, this year). If an investor wants a return in line with the market, and they think they mean the S&P 500, what happens when they under-perform “the market” by 2-3% because of “international exposure”? Or worse, what happens when they don’t have adequate global diversification and actually keep a U.S.-only equity portfolio?

The challenges do not stop at the border!

And this just gets to the decision making of geography! It says nothing about small-cap and mid-cap vs. large cap only. And of course, it says nothing about non-equity asset classes! Do bonds belong in the portfolio? If not, is that investor claiming they can handle a 100% equity level of volatility? And if so, why in the world would someone think it is logical to compare a 60% stocks, 40% bonds portfolio to the 100% stocks S&P 500 index?

Actively disingenuous

The fact of the matter is that all portfolios, whether using index ETF’s or not, require some active construction. From the country/geography selection to the capitalization levels, to the asset allocation – these are active decisions. “Passivity” in the purest sense is not a real option, yet once you say some active management is okay, who gets to say when it stops?

Asking the right questions

At the end of the day, an investor needs to solve for a lot of things in developing solutions that lead to desirable financial outcomes. They need to make sure the costs they pay correlate to a value in excess of said costs. They need to have a sense of what portfolio solutions are tied to what financial objectives. They need to determine what strategies are in order to minimize taxes, to locate certain asset types in appropriate account categories, and to have an idea of how withdrawal sequences matter. And yes, they need to examine what portfolio management approach makes the most sense whether ETF-driven, stock-driven, fund-driven, or a combination thereof. Try as one may, there will never be a one-size-fits-all formula for these things. What I do know, is that I can think of dozens of questions more valuable to answer than the “passive for active” one.

The answer is not in the stars, but in us

Oh yeah. I think I forgot one final point – namely, the most important one of all: An investor’s behavior will always and forever trump any other consideration in their long-term financial success. Leveraging up excessive risk in greed-driven bouts of insanity during market peaks will blow somebody up far more than anything you can think of. And “timing an exit” from the market so they can “buy back cheaper” just in time for the market to go on a multi-year 30%+ expansion will prove fatal (many of you know exactly what I am talking about!). The inclination for investors to capitulate to the human nature of greed or fear is the primary determinant of an investor’s success or lack thereof. So to THIS end, we work, and work diligently.

When recession comes, what will cause it?

At this time, the various metrics we look to in the U.S. economy are all quite healthy.  Bond spreads indicate easy access for corporate money.  Regulations have loosened across the banking sector.  The various “trouble” signs are not flashing at all.  But of course, an unforeseen escalation in the trade war could reverse all of that.  And we do not exactly have many global partners to stand tall with (China, Europe, Japan, emerging all have their own vulnerabilities).  I believe it was 2013 when I first began writing that the next recession would come from a Fed that stayed too “easy” for too long, having to reverse course and tighten too much, too quickly.  I stand by that projection.

The lonely guy in positive territory

I think a little clarity is in order on the year it has been in capital markets. U.S. equity investors are up on the year, a bit. And those sitting in cash are up a bit. Ironically, most who went to cash did so out of fear of U.S. equities were due for a correction. But U.S. equity is the one asset class on planet earth in positive territory this year. Developed international equity investors are not up. Neither are Japanese equity investors.  U.S. bonds are down in total return, and global bonds are down even more.  Gold is down.  Commodities are down.  Emerging markets are down.  Real estate is down.  The reality is that a multitude of asset classes exist to diversify U.S. equity risk, a risk many investors entered 2018 worried about – and in 2018 all of those diversifying asset classes are in negative territory, and only U.S. equities are not.  The irony is thick.

But when you are wondering how you are doing, and think that everything out there is rosy, understand that unless one has a 100% U.S. equity portfolio, with no international, fixed income, real estate, or commodity exposure, chances are there is hardly a monolithically rosy reality to compare it to.

The longest period of media incompetence

The talk about this being “the longest bull market in history” has picked up, and with each pick-up gains more and more incoherent steam.  First of all, a basic question: Did the bull market start in March of 2009, when markets bottomed, or did it start when the last high of the market was reached?  If the bull market started in 2009, that means we are counting four years of this run a bull market, even though all four of those years were spent merely re-gaining levels we had been in throughout 2003, 4, 5, 6 and 7 …  In other words, why does the “catch up from a bear market” count as a “bull market”?

But let’s make a couple other points.  Even if you believe this bull market should be treated as having started in March of 2009, we did, indeed, drop 20%+ in mid-2011 …  Intra-day the drop was over 21%; on a closing basis, it was 19.6% or so.  So yes, that is 20%, and therefore, an interruption to a bull market by the random and arbitrary vocabulary we throw at these things.  I would also point out that while late 2015 through early 2016 did not see an actual bear market, the average stock in the market dropped 25% (h/t Michael Batnick), and earnings growth declined seven quarters in a row (with 20%+ drops in small cap, the Dow transports, and emerging markets).  A 20% drop in the cap-weighted S&P?  Not technically.  But a bear market by any other name …

Ultimately, the real fallacy in this conversation is not just the missed or misunderstood metrics that matter to the conversation, but in actually believing any of this matters at all.  Figures don’t lie, but liars figure.

Lest we forget …

Much press and attention (including from yours truly) have been given to the benefits of repatriation that the new tax law has provoked.  Corporations formerly incentivized to hold cash offshore are now highly provoked to bring it back.  The intention and our belief (accurately) is that this is a positive development – that that capital put back to work in the U.S. is better than the various alternatives.  That said, it is important that those frustrated by the high-interest rates and lower bond prices in short maturities/durations remember – a lot of these companies with high overseas cash were buying $25 billion per quarter of corporate debt, and are now often selling $50 billion worth …  This is a net-net $300 billion difference in the market (less buying and more selling) – and that puts downward pressure on bond prices, and pushes yields higher.  This is technical, it is temporary, but it is real.

But are you positive?

We are well-documented as believing that present pricing in the emerging markets asset class has created a real opportunity for growth-oriented investors comfortable with the inherent volatility of the asset class.  The question when we lay out the thesis that we sometimes get is, “but are you positive?,” which I take to be another way of saying, “are you sure this is the bottom?”  Of course, we never said that – nor would we (about this asset class, or any).  What we are saying is that in the context of appropriate timelines and risk objectives that we religiously manage for our clients, we believe the value proposition (the trade-off between risk and reward) – has skewed towards the side of buying.  And so we are.  And we are positive about this: When it comes to investing timing, no one is positive about anything.

Politics & Money: Beltway Bulls and Bears

  • The corporate tax cut looks set to add $83 billion of money to the economy in 2018, a big number to be sure. But to give you an idea of how big repatriation is on top of that, just Cisco alone is repatriating $67 billion. The data indicates $500 billion of repatriation in the first half of the year, far more than even we forecasted (and we were really bullish on it). There was over $2.5 trillion accumulated offshore before the tax bill, and I believe we are now looking at a big 2019 story as well.
  • One issue that has become interesting to me from a market perspective this week in the Supreme Court hearings for Judge Kavanaugh, is that of the Constitutionality of certain agencies that have a profound regulatory impact on markets (and I do not mean that in a positive way), yet lack normal oversight and process.  Judge Kavanaugh seems to share a skepticism for groups like the Consumer Financial Protection Bureau and the Federal Housing Finance Agency that may have a structure which can best be described as unconventional.

Chart of the Week

Stock prices fluctuate.  Stock buybacks fluctuate.  Operating Earnings fluctuate.  And we certainly know that P/E ratios fluctuate.  But dividends?  Note the relative stability .. (and this is from the S&P 500, not an intentionally-managed dividend growth portfolio)

Source: S&P Dow Jones Indices/S&P Global

Quote of the Week

“No legacy is so rich as honesty.”

~ William Shakespeare

* * *
My kids started school this week and my Trojans played their first game last weekend, so that can only mean one thing: Fall is here (my favorite time of year for a lot of reasons).  The fall of 2008 was not my favorite example of a splendid autumn season, and the fact that we are right now at the ten-year anniversary of the fall of Fannie and Freddie (Market Epicurean – Special Limited Series – Part One – CLICK HERE) is surreal to me.  The memories of where we were ten years ago are not good, and next week will mark the real ground zero event – the death of Lehman Brothers (and then Merrill, then AIG, etc.).  I am writing a series of articles commemorating these markers, but I will say this now ..

Ten years after what felt like the end of the world, I am still dropping my kids off at school (though they are bigger and more mouthy than they were then), and I am still watching my Trojans play football.

In other words, it all worked out just fine.

With regards,


David L. Bahnsen
Chief Investment Officer, Managing Partner

The Bahnsen Group

The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.

All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.

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