Dear Valued Clients and Friends,
Since the markets hit their highs of the year early last week after the announcement of the U.S. trade agreement with Canada, there was a certain deterioration of internal market strength. Each day the market seemed to have some wall of worry to overcome, and the breadth, sentiment, and technical did not feel strong even as bond yields slowly moved higher. By Wednesday of this week the markets gave way, and what had been a 400-point drop in the Dow turned into an 800-point drop by the end of the day (more on that dynamic in the Dividend Café). As of press time, we were down further Thursday, but be that as it may, the entire lay of the land warrants discussion – and so discuss it we shall, in this week’s Dividend Café.
Dividend Café Video
Dividend Café Podcast
What happened this week?
I believe the beginning of the shift from “growth” to “value” officially launched this week, as the reality of rate and monetary policy normalization is working its way through markets. Now, the violence of the drop on Wednesday strikes me as normal investor behavior silliness, where there is a strong and consistent track record of punishing those who behave badly (panic selling and selling into rapid market drops generally leads to a rather brutal lost opportunity). But it would be an incomplete assessment to not point out that when selling pressure accelerates in the final hour of trading, which it seems to almost always do more and more on days already in a meaningful decline, there is a sort of self-fulfilling prophecy at play: ETF selling forces more shares to be sold with no corresponding buyer to meet a market price, leading to a cascading price decline. It is a technical factor, though real in terms of market-to-market pricing, but never the greatest barometer of pure market values.
To put things in perspective, the market has dropped 3% literally 325 times over the last century (3.5x per year on average – h/t Ben Carlson). The large point drop, when interpreted in the price level of the markets, is important (meaning, the % drop is not nearly as violent as the point drop may optically indicate).
Where was the pain most intense?
No question it was the high growth, high valuation, high tech/new tech/cool tech/big tech arena. Amazon dropped over $115 per share in one day (over 6%). Netflix dropped 8.4% in one day. Overall, the tech sector’s drop on Wednesday alone was 4.8%. To the extent the market drop is based on rising bond yields pressuring valuations (forcing a re-pricing of assets around a new valuation metric in the marketplace) it stands to reason that those risk assets with the highest valuation are most vulnerable.
A changing of the guard
It is always risky to make a call that a full paradigm shift is taking place in the markets, especially when it is one that has been forecasted and anticipated for quite some time. My conviction is that the extended period of lofty valuations and expectations for a very specific segment of the market (primarily, large-cap growth tech) is coming to an end, and that while their company performance may be just fine for the foreseeable future, the disconnect from reality in their stock prices may take some time to work its way through. Now, you can’t have this violent of a drop around such an important aspect of market leadership without a spillover into “the good stuff,” but I believe the more attractive market opportunities will prove to be areas with stronger fundamentals and more impressive pricing and dividend metrics in the next market iteration.
Shooting straight on bond yields
The 10-year treasury yield sits around 3.18% right now, down a bit from where it was at the recent peak. The 30-year sits at 3.36%. The yield curve has an odd shape to it, with the heaviest level of “lift” between yields coming between the 3-month and the 2-year maturities (from 2.26% up to 2.86%). I will have more to say about what all of this means for actual bond portfolio positioning next week as I spend a whole day with both our taxable and tax-free bond managers in New York, but let me say this about what bond yields mean now for equity markets …
No matter what you hear in the media, the next move in the market will not be based on the last move in yields. Markets will move based on what they anticipate bond yields will be doing into the future, not what they just got done doing. So it is entirely understandable that rising bond yields would have escalated market volatility, as the valuation we put on risk assets is “based on” some reference rate – some comparative benchmark level. But fundamentally, equity markets respond to growth, productivity, and the profits that follow. Rising growth in the economy requires, creates, and necessitates a higher natural interest rate.
Two responses are fair and warranted:
(1) Yes, these yields moving one leg higher understandably escalates stock market volatility, BUT
(2) It is laughable – and I mean, laughable – that a 30-year treasury yield of 3.36% would strike some as cataclysmic.
Key takeaways from the sell-off
I try to never miss an opportunity to remind readers and clients of pivotally important investment realities that come out of market declines:
- Expected returns are now higher than they were before Wednesday (because whatever the target future price is, it now is getting there from a lower starting point)
- Value is larger than it was before Wednesday (see the next paragraph, but the basic point here is quite simple – earnings did not drop, but the price we have to pay for them is lower)
- Dividend yields are now higher than they were (because of math)
What kind of equity investor doesn’t like the three things I just said ????
How did stocks get so much cheaper??
I am never trying to be coy, cute or misleading when I answer questions about the market being at an “all-time high” by stating that, “no, the market is not at an all-time high.” I know what people mean when they refer to Dow 26,000 being higher than Dow 10,000, but they are not right to assert that Dow 10,000 in 1999 at 29x earnings was cheaper than Dow 26,000 in 2018 at 17x earnings. Again, I am not being cute; I am doing math.
So in that context, stealing as I often do from my mentor, Nick Murray, allow me to explain why the Dow of 26,500 now, is a much lower price than the Dow of 26,500 in January. It is okay if you have to do a double take on that sentence. Yes, I am saying that the number is the same (26,500 as a price level on the Dow), and yes, I am saying one is a lower number than the other. The reason why? We now have the price levels we have on the Down and S&P with over 20% year-over-year earnings growth behind us. In January, it had not yet happened. The multiple then was forward-looking; it is currently a much lower multiple on much higher earnings.
It would be a real disservice to math to claim that this market is not cheaper (by all known metrics) than the January market earlier this year.
Jobs jobs jobs
The job creation number for September was only 134,000, lower than the 185,000 expected, but there were revisions of 87,000 (to the upside) for July and August. The unemployment number dropped to 3.7%, the lowest in 49 years. Wages are up 2.8% vs. one year ago. Hurricane/weather impact on everything is hard to measure. No matter how you slice it, the jobs picture in the American economy is very, very solid. I spoke about this a bit on Varney on Fox last Friday
The old big story vs. the new big story
I talked about this on last week’s Dividend Cafe video, but I really can’t say enough about the significance of the entire bearish thesis du jour completely changing. We have spent the bulk of the year being told that an inverted yield curve spelled doom for the markets, as the long-term rates stayed flat or moved lower, while the short-term rates moved higher (they didn’t invert, but have flattened most of the year). Now, the yield curve has widened quite a bit and the new thesis du jour for is higher rates. I do not mind the validity of thesis A or thesis B, but I do mind the thesis changing on a whim (when they are in direct contradiction to one another).
Higher rates have not – I repeat, not – historically been bad for the stock market. Sustained periods of rising rates brought about by sustained periods of inflationary pressures certainly have been. There is more evidence that long rates are moving higher due to a strong economy than there is evidence that they are moving higher out of inflation concerns. We expect the markets to settle as long rates settle, and long rates to settle 25 basis points or so higher than where they were for most of the year.
Is China going to hit us where it hurts?
Could China begin selling its $1.2 trillion of U.S. Treasuries as leverage in the present trade war? Wouldn’t this push yields higher, and make U.S. borrowing costs grow, thereby hurting our economy just as much as the imposition of tariffs by us may be hurting theirs? It’s a reasonable question, but the fact of the matter is that China desperately needs a cheap Yuan to stay afloat as a huge exporter, and there is no way they could dump hundreds of billions of dollars of dollar-denominated Treasuries without substantially rallying the Yuan, hurting them as much as it would hurt the United States.
Talking straight on the U.S. dollar
Let me make something as clear as I can: Yes, the dollar has risen this year, and yes, that has had an impact throughout various capital markets, globally and domestically. But consider this – you have a Federal Reserve that has clearly been as hawkish, or more hawkish, as anyone could have expected, you have a U.S. economy outperforming every economic region in the world, you have a real significant decline in emerging markets, you have Italian bond spreads that have widened dramatically, and you have oil prices at four-year highs. AND YET, the dollar has not appreciated that much. +2.5% over the last 12 months is not barn-burning stuff.
Politics & Money: Beltway Bulls and Bears
- I continue to be curious what the impact of the Kavanaugh matter will be on the electorate in these midterms. I have taken for granted all year that the House was likely to go from red to blue, and midterms being what they are, it would be very uncommon if it did not. But certain things that are market sensitive, like a possible Tax Reform 2.0, could take on a very different face if by some twist of fate the Republicans maintained control of the House. Is there a midterm scenario that I see being detrimental to markets? No. And I believe the Senate is highly unlikely to change control. But all of this is worth watching in the weeks ahead.
- I’ll have more to say next week about the Senate’s Banking, Housing, and Urban Affairs Committee meeting on Thursday regarding the crypto-currency ecosystem. The widespread criminality associated with the medium has many lawmakers very concerned.
- 18 out of 18 of the last “years after a midterm election” the market has been higher. The problem with that statistic? It does not tell us about the 19th time. But it warrants sharing nonetheless.
Chart of the Week
I know this may be hard to read, but it really is well worth it. Dividend Cafe readers know the disdain in which I hold “perma-bears.” I think just looking back the last six years, well after the initial major bounce post-crisis took place, you will note a lot, and I mean a lot, of reasons to run for the hills. And you will note a market that goes from low-left to high-right on the chart. Does this mean markets go higher yet still? It means this: There are always reasons to justify abandoning the discipline of your plan – always. Yet abandoning your plan can be fatal for your financial goals.
Quote of the Week
“Investing without research is like playing stud poker and never looking at the cards.”
~ Peter Lynch
* * *
I am in New York City until the 21st, and in the week ahead will be joined by fellow Investment Committee members, Deiya Pernas and Brian Szytel. This represents the 13th straight year of due diligence meetings with our key asset management partners, and one of the most important weeks of the year for me as Chief Investment Officer. We are relentless at The Bahnsen Group in our quest to understand capital markets and to properly position our client portfolios around the risk/reward trade-offs that we see in the investment landscape. We hold our managers accountable to their processes and principles, and we are constantly seeking to learn more and to challenge our own viewpoints. I fully expect this year to be no different than the last twelve years, both in terms of the value the meetings provide for us, and the actionable takeaways that make their way into client portfolios.
Research drives our process. To that end, we work.
Smart behavior drives your results. And to that end for you, we work as well. “This is no time to get wobbly.”
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.
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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