Dividend Café


Market Volatility and YOU - April 13, 2018

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Dear Valued Clients and Friends,

Elevated market volatility continued this week, even as some of the specific trade and tariff rhetoric seemed to have stabilized a bit.  Questions about military action in Syria, the retirement of Speaker Paul Ryan from the House, the highly-publicized Congressional testimony of the Facebook CEO, and yes, the FBI raid of President Trump’s personal attorney’s office, all dominated the news. I don’t know about you, but these four stories all seem like they would make it one of the biggest news weeks of the year in normal times.  But alas, it was almost as if it were a slow news week these days, which is truly a surreal statement about the era in which we live.

This week’s Dividend Café features one of my favorite segments in terms of practical investor understanding and behavior I have ever written.  I think you’ll also find some pretty caffeinated coverage of interest rates, emerging markets, MLP’s, and so much more.  Come on in!

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My favorite paragraph I have written in Dividend Café, maybe ever

I have written for nearly twenty years of the pivotally important truism that “risk” and “volatility” are not the same thing – that risk is the possibility of a failure to achieve a financial goal, whereas volatility is the up and down movements of value in asset prices inevitable in the life of any investor.  With complete economic logic and empirical support, I have sought to define volatility as a key ingredient in “risk premium” – meaning, the cost of the premium return that investors receive to be invested in an asset class like equities.  If there is anything I will never tire of repeating for the betterment of my client’s understanding and well-being, it is this.

I am also aware as to why this understanding of volatility, while intellectually irrefutable, is not always emotionally adequate.  During periods of volatility, one does not necessarily seek refuge in the Investopedia definition of “equity risk premium.”  My mentor in this business, Nick Murray, defines risk as the “exposure to an impairment of my standard of living and/or a permanent, irretrievable loss of capital (1).”  So when markets go through periods of enhanced volatility, one first has to address the substance – “is my client’s quality of life actually threatened by this?”  If an investor has put all of their money in a tech fund, and they need to pull it all out in 30 days to pay for a wedding, I would say that they have more than just the quality of their life to worry about!  But if we as financial planners, advisors, and professionals have done our jobs right – understood the liquidity needs, planned for the proper access to capital, at the right and needed times, and done thoughtful matching of solutions to resources and needs – and one’s bucket of accumulation capital, or even dividend-creating income capital – is experiencing up and down movements in value, in what way is one’s standard of living threatened?

The answer is that when planning has been done, it is not.  So the first box can be checked.  We are paid to make sure that box can be checked.  And any failure to have that box checked is malpractice.

BUT that doesn’t end the discussion.  For even where no possibility of market volatility leading to an impaired standard of living exists, fear, insecurity, uncertainty, and questions can linger.  “What if the market volatility we are suffering now does nothing to impede my standard of living, but one day it will?”  It won’t – but is that questioning normal?  Of course.  And what is the antidote to it?

It is us.  We will do the two most important things in periods of such questioning that can ever be done.  (A) We will listen.  (B) We will keep one from acting on such questioning in a manner that will guarantee the outcome they are so desperately afraid of.

Put differently, the fear one has in periods of volatility of a compromised quality of life will not come to fruition, but by the fatal decision to act on such fear.  So to that end, we work.

“New Tech” is Troubled Tech?

I did a special edition of our Advice and Insights podcast this week entirely covering the subject of “new tech” and its relationship to society.  Our forecast of some time back that the sector was entering a new paradigm of headwinds in how social and political forces embrace them has been playing out on a daily basis in the headlines and press, but I recommend the 20-minute podcast for you to hear more of the specific investment implications behind it all …

Something to be energized about?

Longer-term readers will remember the heavy focus on correlation between stock prices and oil prices in the early months of 2016, and our study of how (in that environment) risk assets were all so heavily correlated around that one particular theme (if oil prices were folding over, it likely meant China was, and that was bad for all commodities, and high yield bond paper was heavily invested in energy companies, and no one knew how much exposure the banks had, etc.).  In other words, the contagion effect in both cause and effect (negative feedback loop) was significant around oil prices in that era.  In other eras, a declining oil price has been associated with a positive environment for stocks, not negative.  Declining oil prices in the 80’s indicated the defeat of the 1970’s inflation, and few things have ever been celebrated by the stock market like the defeat of 1970’s inflation.

But what is going on now?  Stocks are in elevated volatility.  The Trump administration is indicating a willingness to suppress economic growth in order to work on “better trade deals.”  The VIX has blown out.  And yet, oil prices have not budged – a $60 to $65 range has impressively stuck.  Oil was, in fact, the best performing asset class of Q1.  The disconnect between this and energy stocks (so far) is fascinating.  Some may use a different adjective.

Feeling better about bonds

One of the amazing things taking place in capital markets right now, beneath all the questioning around equity market volatility and the like, is the relative stability of bond yields since that flush-out back in early February.  The ten-year has settled quite consistently around 2.8%, not 3% some feared, and not 2.6% where things started the year. In fact, bonds have more or less traded in reverse correlation to stocks as the trade/tariff related stock market volatility has ensued over the last six weeks (in other words, more in line with historical expectations).  My great fear earlier in the year was not that stocks would drop, but that if they did, bonds may very well drop with them (as opposed to serving as the portfolio mitigator they have historically been).  At this point, I would continue to suspect a volatile ride is in order for equities, but I do believe that, if there were to be a “risk-off” trade in capital markets, those who are holding bonds that act like bonds will be much better off.

Deficits create higher interest rates except for most of the time when they don’t

Investors care about bonds to the extent that they wonder how bonds are going up or down in price, and/or what their bonds are paying them in income. The actual machinations that cosmically move the bond market are not often front and center in your minds, and I can understand that.  But beneath the hood, it is important to remember that it is, always and forever, macroeconomic forces that drive interest rates, and it is interest rates that drive bond pricing.  When we talk about the macroeconomics behind long-term interest rates, we are largely talking about budget deficits, as the bonds the government sells into the market to fund budget deficits are the key mover of these long-term forces (combined with inflationary expectations, etc.).  We know budget deficits are projected to rise, and so to generate a coherent view of what this will mean for long-term interest rates, we have to look under the hood.  Saying “rising deficits will mean higher rates” is not only simplistic, but it is factually decimated by the cruel testimony of history.  Deficits were larger from 2008-2013 than at any time in history, and yet interest rates were collapsing (and if you yell back, “yeah, because of the Fed,” you haven’t disproven my point at all).

Okay. Give us the caveats and application.

Fundamentally, the reason so many rate forecasters get this stuff wrong (how long-term rates will respond to rising budget deficits), even when the facts are reasonably known (spending increases and tax decreases will expand the deficit), is because a key factoid remains unknown – what will the primary source of funding be?  If U.S. banks were buying the treasuries the government sold into the market, it would not push rates much higher, but it is doubtful they will look to add to their balance sheets when the Fed themselves is shrinking their own.  Private investors (non-banks) could become huge buyers of Treasuries, but as you know, we actually believe they will be highly driven by business investment (capex) post-tax reform, and are not likely to seek the safety and shelter of government treasuries.

So if the buyer is not banks, private corporations, or the Fed, that leaves us with what option (as for who can buy higher issuance of government treasuries without pushing interest rates higher)?  You guessed it – foreign buyers.  Same as it ever was.

And how do the Chinese and Japanese fund their purchases of our debt?  With the cash we give them when we buy more of their exports than we import to them (this allegedly disastrous trade deficit).

Do you see my point?  As we hear talk of the trade deficit spelling doom and gloom every day, It is entirely possible that that very trade deficit is what will be needed to create foreign demand for the treasuries needed to fund our deficits without spiking interest rates.  Oh, what a tangled web we weave, when first we practice, to do bad economics.

The emerging markets story in all of this

While the U.S. equity markets play tit-for-tat with trade talk, China, Trump, Kudlow, and the rest, the emerging markets story has been interesting to watch.  Not only has EM withstood the equity volatility of U.S. markets, but the global growth story has created more capital flows into emerging markets, resulting in stronger EM currencies (up 2-3% on the year), which then stirs credit creation and more domestic demand.  Now, it is important to say that the domestic demand story on an individual company basis is what we invest for here but to point out the macroeconomic conditions all reinforcing it at this point in time, seems fair.

Where MLP’s fit into earnings season

I suspect that Q1 results in the MLP space will go a long way towards dictating investor appetite and sentiment for the space in the near term.  Should higher organic cash flows be evident throughout Q1 results, you may see prices being bid up, which actually is a bigger deal than just the obvious fact that the values of the investments may be higher.  Should MLP’s find their footing in valuation, it becomes a funding vehicle for many of the entities, who otherwise may right now be very interested in converting to a C-corp structure (to have lower capital costs from what would presumably be a broader base of investors).  In other words, the very structure of many of the leading MLP names could change based on how solid the investor base proves to be in the near term.  Fundamentally, this asset class is under-priced, and perhaps dramatically so.  But for that to matter, the market has to perceive it as such, and I think Q1 results will be quite telling in terms of how leading MLP operators choose to formulate their financial structure and funding mechanisms in the months ahead.

Chart of the Week

I will talk about dividend growth stocks as the antidote to a lot of different things, from accountability in the c-suite to shareholder alignment to investment de-risking to smoothing of equity price volatility …  But in the present context, it also needs to be talked about in the context of a rising interest rate environment …  The study from Ned Davis Research in this week’s Chart of the Week is clear about a few things: How differently different types of stocks (as far as their dividend treatment is concerned) respond to rising rates; and how positively the dividend growers respond!

Quote of the Week

“Of all tyrannies, a tyranny sincerely exercised for the good of its victims may be the most oppressive.”

~ C.S. Lewis

* * *
By this time next week, we will be well into earnings season, and I do not recall a higher anticipation for an earnings season than this one in many, many years.  And by this time next week, tax season will be done.  So in other words, I think I will be sending next week’s Dividend Café with even more joy in my heart than I have right now (though I have plenty of joy now, too).  We enter earnings season anticipating high dispersion of results, and the belief that too much noise has dominated the investor airwaves for the last ten weeks.  The fundamental task of a devoted wealth management firm – and we are nothing if not devoted – is to steer investors towards the successful achievement of their objectives.  We view noise as a threat to those objectives, so it is the burden of Dividend Café to counteract noise, and focus on what we believe matters.  To that end, we work.  Enjoy your weekends!

With regards,

David-Full-Signature-Transparent-300x52

David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner
dbahnsen@hightoweradvisors.com

The Bahnsen Group
www.thebahnsengroup.com
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.

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) Nick Murray Interactive, Volume 18, Issue 4, page 2

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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.