Dear Valued Clients and Friends,
It has been a rough week for the markets primarily centered around a sell-off on Tuesday that comes amidst a very solid earnings season. How exactly can earnings and revenue results be coming in so solid and yet markets still gyrate or sell off? We will answer that question quite exhaustively this week, and cover so much more in this week’s trip into the Dividend Café (one you will not want to miss).
Dividend Café Video
Dividend Café Podcast
Have earnings disappointed so far?
Oh quite the contrary! 81% of companies who have reported have beaten their already ramped up profit expectations (out of 155 companies), and 65% have beaten in top-line revenues. The “E” of the P/E is going up! The issue is that “P/E” (the multiple) – the amount an investor is paying for a degree of earnings) – is coming down. And why would a multiple go down in a rising rate environment? The sophisticated answer is that the discount rate is increasing; the simpler answer is that as interest rates go up, the competition for those earnings goes up too. So when you divide the earnings by a higher competitive rate in the marketplace, it makes the earnings less valuable. Now, is 3% in the 10-year bond yield really that much of a difference from 2.88% (or whatever)? Of course not. But if the market fears a 3.25% bond yield, or 3.5% level, it does require a re-pricing of equities!
Are bond yields going to 3.25% or 3.5%? We don’t think so. But in a market already skittish by the short term rate rising (which the market has known forever, and not cared about), and already skittish from Fed balance sheet normalization, and already skittish from potential trade/tariff fears, and already skittish from an expected “blue wave” in the midterm elections, it is completely understandable that valuations (which started at a pretty full level) would be vulnerable.
Any suggestions how to get through such a period?
Ummmmm, yes. Thank you for asking. Don’t buy brutally over-priced stocks. Focus on already reasonable if not cheap valuations. Look for dividend growth. And be extremely aware of the historical reality around this price volatility. It is an opportunity, not a source for fear.
Biggest story of the week?
If there is a bigger story this week than this, I don’t know what it is …
* FactSet, U.S. Ten-year Bond, April 24, 2018
Now, this can become a story of bonds eating into the pricing/valuation/global allocation of equities, and can become that very quickly. With that said, should real inflationary pressures surface, there should be no sugar-coating that it would not be bullish for stocks. The transition from structural disinflation to real inflation is not one we believe will happen quickly, if at all. The forces that have created such a deflationary environment (in the U.S., but also globally) for such a long time (technology efficiency, globalization, demographics, sovereign indebtedness constricting growth, etc.) are economic anchors we are not prone to ignore. And yet, we have to heavily dissect the data for potential interference with the deflationary thesis, and impact to our desired asset allocations that inflationary forces would surely represent.
TIPping our hand
In terms of the ramifications to bonds, one must believe inflation is going higher still (not merely that it has already gone higher) to find TIPS an appropriate defense in a bond portfolio. We are weighing that possibility now in our fixed income weighting. But if we believe core inflation may modestly rise, but not spike, TIPS may not be a wise vehicle.
MLP Mania or Mayhem
Our never-ending need to review (“MLP” is just a company accounting/structure term – it stands for “Master Limited Partnership; but when we use the term, and almost always when you hear the term in the context of investing, it is a reference to oil and gas pipeline companies who for a variety of tax reasons have chosen this structure. The need to clarify what MLP’s are was highlighted for us recently when Fox Business put up the company “Maui Land & Pineapple” when I was discussing MLP’s on air!).
The MLP/oil & gas pipeline sector was up over 3% last week, and was up over 3% the week before that. The space remain in negative territory on the year, but with yields well above 6%, that can change quite quickly. Indeed, a 3%+ week for two consecutive weeks has happened just 11 times since 1996 (h/t MLPGUY.com). Has there been a real change in sentiment, or are the last two weeks just market prices playing catch-up with a more favorable commodity price environment? Time will tell. What we think has to take place for a truly paradigmatic shift in sentiment is not merely the often silly joy that comes from sustained commodity prices, but rather real and true and voluminous announcements from the companies in the sector that point to funding capability, project execution successes, and favorable outcomes around regulatory question marks. What delays this shift is disingenuous tinkering from management, surprise capital allocation challenges, and regulatory vagueness.
Our outlook is for clearer skies ahead. And if that doesn’t work, you can always go to Maui and eat fresh pineapples … =)
Our EM is not your EM
I am quite sure it has been ten years now that I have been writing of how our approach to emerging markets investing is simply not the same as the approach one hears chatted about in financial media or the cookie-cutter asset allocation reports of most Wall Street brokerage firms. While we would agree that, generally speaking, we call a country an “emerging market” if it is presently not an advanced economy (third world?), but is progressing towards being an advanced economy, with demographics and other such external circumstances aiding the cause (generally the advent of some form of market capitalism). In any such investment approach, a higher volatility can be expected, in theory, because of geopolitical risk, or the fact that the country’s institutions and infrastructure are, shall we say, a work in progress. But where our emerging markets approach strives to be different, is that most essentially just function as a very high beta play on developed markets. This is to say, the correlation is quite high with the U.S. stock market, only the highs are higher and the lows lower. This is not our approach.
What makes most vanilla EM investing as such is quite understandable. The companies being invested in are essentially levered trading partners to developed traditional economies, so levered cyclicality is quite literally what you get. But we favor bottom-up, company-oriented investing, with a strong bias towards domestic growth. We see emerging markets investments outperforming the U.S. stock market, with less volatility, and believe this can continue. Growth fundamentals are ultimately what should be invested in, and those growth fundamentals are there with high Return on Equity, high Return on Invested Capital, and valuations that don’t look like 1999 all over again.
For a pretty informative dive into our view of EM investing, check out this Advice & Insights podcast recorded earlier this year with one of our key EM investment partners.
Dropping in on Japan
It would not be easy to justify our bullish take on the Japanese corporate sector, particularly in the dividend growth space, if it were not for corporate profits. And yet, profits are at record levels, even as valuations sit where they were in 2011. Capital spending is meaningfully on the rise, and the business environment is healthy. All in all, we don’t like that Japan gets brought into the mix when President Trump makes trade threats at China. Truthfully, the valuations suggest what you would think they would suggest – an investing world that has mostly left Japan out after 25 years of Japan’s inability to perform as a global equity player. But we see business conditions and Return on Equity going the right way for the corporate sector, and believe value investors should be paying attention.
Rising rates for me, but not for thee
Okay, so maybe rising interest rates are not spelling doom and gloom for the S&P 500. But surely the REIT world (real estate investment trusts) are rate sensitive, right? I have written about this for many years, for in certain day to day contexts it can feel like REIT’s are inversely correlated to higher rates. But actually, history is rather unambiguous about this: In periods of rising interest rates (3-month windows), REIT’s have performed positively 87% of the time. REIT dividend growth has outperformed inflation in 18 of 20 years (1). The huge misnomer here is simple: Rising rates that reflect economic growth, and economic growth is positively correlated to REIT investments.
Get back to me in December, but …
A rather thoughtful line of reasoning we had at the beginning of the year went something like this:
- Tax reform was going to be bigger for company earnings than the market had priced in …
- But that disconnect from the reality and market pricing was mostly to be actualized in small cap companies, as large cap had largely priced in much of that positive reality
- But buying an index for small cap would not capture this thesis adequately, as such a high portion of the companies in the index do not even earn profits (so therefore do not benefit from a lower tax on profits)
- Therefore, small cap, ACTIVELY managed, represented a very investible thesis
We will see how this plays out over the full year, but thus far it has proven to be an extremely cogent line of reasoning, with active managed small cap proving to be one of the best relative and absolute performers across all asset classes.
Are you sweating the staples?
The worst performing market sector this year is not energy, but consumer staples (companies that make those consumer products you just have to have, like diapers, toothpaste, and more). Why would such a reliable sector with attractive dividends and stable earnings be struggling in a solid market environment? The biggest reason is just market multiples – their earnings do not fluctuate a lot, so when you see P/E ratios adjusting it moves the needle. However, they also are heavily dependent on commodity prices as an input to their cost structure. As rising inflation expectations have pushed commodity prices higher, consumer staples end up with a declining profit margin. Consumer staples, though, have the extraordinary ability (via pricing power) to pass on those costs to their customers. That process just takes time to work its way through the economy …
Chart of the Week
Our strong commitment to alternative investments has been a hallmark of our risk management and portfolio construction for many, many years. Due diligence is key in the world of alternatives, because, as I never tire of saying, the risk is merely being replaced (from the beta of stock and bond markets in traditional investments, to the manager talent risk of alternatives). We consider our efforts here a source of pride at The Bahnsen Group. Reinforcing the need for selection in one’s alternative allocation is the basic empirical reality that the difference between top managers and bottom managers (and between top managers, and “median” managers), is HUGE with hedge funds and private equity (not as much in traditional stock and bond categories).
* iCapital, Democratizing Alternative Investments, April 2018, p. 10
Source: (1) Investment Metrics. Represents 10-year time-weighted return as of September 30, 2017. (2) Source: Eurekahedge and Bloomberg. Returns from December 31, 2009 through December 31, 2016. (3) Source Cambridge Associates, 10-year pooled investment horizon IRRs. Data as of June 30, 2016
Quote of the Week
“Winning is a habit. Unfortunately, so is losing.”
~ Vince Lombardi
* * *
We will have an even fuller read on earnings season by this time next week. So far, we like what we see in the micro but see a lot of skittishness brewing in the macro. No doubt this is a volatile time in U.S. equities, and we intend to manage through this with competence and care. To that end, we work.
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner
The Bahnsen Group
The Bahnsen Group is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, SIPC & HighTower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through HighTower Securities, LLC and 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 described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee.
This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of HighTower Advisors, LLC or any of its affiliates.
(1) First Trust Market Watch, April 23, 2018
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.
This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.
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