Dear Valued Clients and Friends,
We followed the craziest week in the markets in 18 months with a pretty big rebound week – consistent, steady, but meaningful price recovery (at least as of press time). Technical and structural factors in market movement seem to have subsided (though we trust the precedent set will not be forgotten – more on that in the café), and the conversation is now all over the map as to what should be expected from basic market fundamentals. We take all these topics and more head on this week, and maybe, just maybe, do it without boring you to tears. And we do a really comprehensive “listener questions” podcast at Advice & Insights. So come on in to the Dividend Café …
Dividend Café Video
Dividend Café Podcast
The Lesson that is and the lesson that isn’t
It is our firm conviction that most of the specific insanity of the panic attack correction of last week had deep structural and technical roots underneath it. Much coverage has been given to how the need to unload various inversed and leveraged and rather silly products has exacerbated this market volatility, and added to the pile-on of market movements during the sell-off. We therefore have a duty to ignore false signals (noise) that come out of transitory, structural flaws in mechanical market functions.
But that is not to say that there is not a greater narrative at play across capital markets, perhaps less relevant to the specific violence of down 1,000 point days, but very relevant to how one wants to be positioned as an investor. If one believes, as we do, that the overall environment is in a subtle shift from deflationary pressures to inflationary ones; from tepid growth to greater growth; from monetary stimulus to fiscal stimulus; then the portfolio trends of the next five years would understandably look different than they have the last five years. For us, this means the opportunity of growing cash flows become more appreciated than the mere aspiration of a higher P/E ratio. But it also means that global economic shifts create greater uncertainty and volatility as they play out.
If you accept that the major thing that will move markets for now is either the news about inflation or the concerns about potential inflation, the consumer price index figure for January was probably of great interest. The index rose 0.5% in January, vs. 0.3% expected. This amounted to a +2.1% increase vs. a year ago. Energy prices were up 3%, and food prices +.3%. Interestingly, hourly earnings were down. “Core” prices were on the rise, and our view that 2018 will amount to a paradigm shift in conversation around inflation and inflation expectations is well in play.
But let’s be clear. We are nowhere near ready to say that this means inflation is back and staring us in the face. The numbers were not at all daunting year-over-year, and markets were up 250 points the day of the CPI release (Wednesday). We know short-term “conversation” about inflation has created tremendous market sensitivity, but we are also cognizant of the fact that most central banks of the world (including our own) have spent a decade trying to create inflation, unsuccessfully. The biggest issue we have to deal with is that “conversation about inflation” is not the same thing as inflation, and higher wages most certainly do not cause higher inflation. (I spoke about this on Bloomberg TV this week). Flawed economic ideology is behind a lot of this confusion. But an “all-weather” portfolio approach has never looked so wise to us!
History and Volatility
I am more sympathetic than you might think I am to the fact that what has happened frequently in the past doesn’t have a lot of bearing to how we feel about the present. Nevertheless, our job is to present facts and data that have a bearing on you as an investor, even if they are insufficient in therapeutic value. And the fact of the matter is that we have had unnaturally low volatility for a long, long time, and in the last couple weeks have gone to a super-natural increase of volatility. We were “overdue” for this, and yet it quite quickly became “overdone.”
** Virtus Investment Partners, 1,000 Words, February 2018
Enough about markets. Let’s talk economics.
Q1 real GDP growth is projected to end up being over 3%, and we do believe 4% (for this quarter anyway) is a distinct possibility. Retail sales are up 9% (annualized) over the last six months. The ISM Manufacturing print was the best in seven years in January. The ISM non-Manufacturing read was the best in a stunning fourteen years! Hourly earnings were up 2.9% vs. a year ago. Earnings appear to be up 17% year-over-year this quarter. Global metrics are in an upward trend nearly across the board. Productivity has likely bottomed and is geared for pick-up. Durable good orders were up 2.8% last month. Consumer sentiment at historically high level. 200,000 jobs were added last month. So, markets can go up or down in good or bad economies, but for those wanting to simply know how the economy is doing, the data is rather clear.
Re-pricing of stocks in tug-a-war
There seems to me to be two conflicting forces that are and will call for a re-pricing of stocks in the months ahead: One is the higher bond yields we see taking hold in response to higher inflation expectations, and tighter monetary policy. A higher interest rate compresses equity premium, for obvious reasons. The second is the higher volatility environment for stocks relative to the low volatility environment we have been in. Higher volatility enhances expected rates of return, as the risk premium investors demand for higher volatility assets increases. A re-pricing of equities and sort of clearing the deck of asset prices is a normal and healthy thing. In this case, there are a couple forces at play which will impact expected rates of return for the U.S. equity asset class.
Not a convenient truth – just a pivotally important one
There is no need to look for “spin” in this environment. The markets have done what they have done and the next phase will be what it will be. As long-term investors committed to client outcomes and goals, we don’t “spin” current events because frankly we don’t need to! So take this as the objective fact that it is – despite a brutal market correction in stocks, corporate bond spreads did not widen. This makes no sense at all if we were facing a fundamental re-visit of systemic risk. Rather, it seems to us, to indicate market structure issues behind the correction much more than economic fundamentals.
The tragedy of higher wages???
I will push back as long as there is still a reporter or professor uttering what virtually all economists now know to be patently false – that higher wages cause inflation. The theory is that as employees start getting paid more, they go out and spend more (pushing up demand), and that then causes producers to raise prices. Then, everyone catches on, and voila – higher prices everywhere (i.e. inflation). But there are so many flaws in this thinking it fails on its face. Inflation is an aggregate price level across society; wages are one aspect of a complex economy and exist within the context of competition for labor, supply and demand, and a whole host of factors. An increase in money supply above and beyond the increase in goods and services is inflationary. Employers and employees cannot create inflation; they can only respond to it.
The behavioral reminder
The $29 billion of net net net money being SOLD from retail equity mutual funds last week (1) has all the evidence of being classic “weak hands” money. What do I mean by that? I mean people that were convinced not to be in stocks at Dow 18,000, or Dow 20,000, or Dow 25,000, that then came in at Dow 26,500, and upon the first bout of volatility, jumped out. I have written about these second order and third order effects of market timing before. First, people are mad about their own exit timing. Then, they are mad about their re-entry timing. And then, they become incapable of reasoned decision-making. It happens over and over again. What is the behavioral remedy? Avoid painful third, fourth, and fifth dominoes by never tipping over the first domino. Market timing is a fool’s errand, and makes for “weak hands” when finally invested in stocks. And no one with weak hands will ever survive invested in equities.
As for the theory that this was “mutual funds,” but the “passive” owners of non-managed assets in ETF’s do or did better? Well …
When things get this screwy, they also get this good?
“Backwardation” is an awkward word, but it is an important one in financial markets, particularly for those of us dealing with the futures market. When it comes to the “VIX” (the so-called ‘fear gauge’) of the S&P 500, it is simply the state of people paying more for protection for short-term contracts (say, thirty days) than they are paying for longer contracts (like, ninety days). It is counter-intuitive to the core, for surely the more time there is, the more potential for a mishap that would warrant protection. Therefore, when costs invert like this, where protection for ten, twenty, or thirty days cost more than protection for ninety days or longer, it speaks to a real distortion in the market. Well, the VIX entered such “backwardation” last week, and we thought the following chart may be helpful to illustrate two things when this kind of silliness happens:
(1) Volatility is enhanced
(2) Market performance out of such phases has historically been stunning
* Invesco Asset Management, February 7, 2018
I would say it myself, but someone else said it for me
Stock market rallies 300%
permabear: I was right.
— Downtown Josh Brown (@ReformedBroker) February 9, 2018
Chart of the Week
We really should re-post this chart a couple times per year, at least. But essentially, the red dots below show the lowest point the market had been in a drop that particular year, and the gray bar shows how the year actually ended in market return. As you will see, intra-year drops of 5-10% are the NORM, even in and especially in very positive market years.
Quote of the Week
“It is a popular delusion that the government wastes vast amounts of money through inefficiency and sloth. Enormous effort and elaborate planning are required to waste this much money.”
~ P.J. O’Rourke
* * *
We do hope that our heavy communication around the market drama of last week has been helpful. I am quite impressed at how little disturbance there seemed to be amongst our clients, and hopeful that some part of that can be traced to our efforts to educate, communicate, and engage. I’ve been deeply inside the bond market this week, looking at the yield curve, looking at spreads, and trying to make heads and tails of what interest rates are telling us. I remain somewhat neutral about risk positioning. I see the strongest movement from corporate tax reform in terms of wage growth and GDP growth still to come, and yet also cognizant that stock prices have priced in a lot of this, and are right now sensitive to jolts. So we stay balanced. We stay prudent. We avoid greed and we avoid fear. And most of all, we communicate. To that end, we work.
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner
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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