Dear Valued Clients and Friends,
What a week – and I don’t mean the week in the market – but rather, the anniversary of not one but two of the most ghastly events in American history. First, and most solemnly, the 17-year anniversary of the terrorist attack of 9/11 was on Tuesday. As always, the memories are provoked are haunting, and the lessons learned seem inadequate. But this week happens to also represent the 10-year anniversary of the week that represents the epicenter of the financial crisis. I am writing at www.marketepicurean.com a day-by-day commentary about the crisis, coinciding with the actual calendar day developments as they were ten years ago. The Fannie Mae/Freddie Mac issue launched the series last weekend, and the Lehman Brothers issue has gone live today [Ground Zero: The Fall of The House of Lehman]. Over the weekend the Merrill Lynch issue and AIG issue will go live, and then on Monday, the day “Wall Street almost died” issue will post. For those interested, I am keeping the articles short but hopefully interesting. At the end of the series in a couple weeks, there will be a whole “tie-in” for investors as to what investors learned from the crisis, and what actions are appropriate in its aftermath to this day.
In the meantime, there’s plenty of stuff to talk about in the here and now, so come on into the Dividend Café …
Dividend Café Video
Dividend Café Podcast
Getting comparisons out of every category in every decade
To understand valuations in the stock market or any risk asset, one has to consider the inflationary environment, the earnings growth, the prevailing rate in the bond market (cost of capital), the tax context, and overall economic environment. This chart from my friends at Strategas provides the evidence-based fodder by which some may conclude (as we do) that valuations are healthy but not overdone, that inflation is low, that growth needs to increase, and that the lower tax environment matters.
* Strategas Research, Investment Strategy Report, p. 2, September 10, 2018
Update on the Fed
The futures market says that there is now 82% chance of both a rate hike in September and December … That number had been 62% just a week ago (presumably the strong job and wages number pushed the odds higher). The September odds are essentially 100%, and with December futures saying 80%+, we are extremely close to considering it assured.
Not academic economics – this is the stuff that matters
Does a yield curve inverting point to a future recession because of something graphic on a chart, or does what is graphic on a chart simply tell a fundamental story that speaks to the reality of recessions? Obviously, it is the latter. With all of the talk about concerns over a flat yield curve, it concerns me how many speak to a certain dynamic without the foggiest idea of why that dynamic exists or what it means.
An inverted yield curve points to something, it is not the cause of something, and what it points to is this: Interest rates being higher than the economy-wide return on invested capital. That “inversion” is not organic, is not normal, is not natural, and cannot be sustained. The marginal rate of return on capital must be higher than the cost of capital, or this unnatural force will be purged via a recession. Return on invested capital increasing allows a cost of capital to increase, but the relationship between the two tells us the most important thing we need to know about economic health.
Yeah, but …
One of the strangest arguments against the sustainability of profits growth is the argument that it has only happened because of tax reform … I am not sure why an investor is supposed to find that catalyst illegitimate or unsustainable. But also, it is inaccurate. Strip out tax reform, and you still have organic earnings growth of 13% year-over-year. This is remarkable.
Nothing to see here?
The idea that market volatility and headwinds this year are not related to the trade war/tariff issues might have an inconvenient data point to deal with here:
* Strategas Research, Policy Outlook, p. 5, Sept. 11, 2018
Re-understanding trade war leverage
There is a narrative popular with some (not all) in the Trump administration that the U.S. has the leverage in the trade war with China, and that China has a lot more to lose than we do. They point to the drop in the Chinese stock market since this all has unfolded vs. our own market. There are some deep flaws in this analysis. First of all, the relative stock market performance as a barometer of trade leverage presupposes that stock market strength or weakness means the same thing in China as it does here; nothing could be further from the truth. But there also needs to be a better economic understanding of the difference between short-term and mid-term/long-term impacts. The bulk of what we import from China amount to goods that long ago became cheaper to make in China than the U.S. The factories needed to replace that manufacturing in the U.S. are not going to be built if we are one trade deal away from that business going back to China. The tariff threat is not pushing manufacturing back to the U.S. (for which it is not equipped to do), but rather is simply pushing the fiscal impact on to U.S. consumers. If this response becomes unacceptable, which through time it will be, there is a better chance of a different foreign country being selected for said manufacturing than it coming back to the United States. So tariff threats and mild implementations become more political, cosmetic, and rhetorical than they do substantive – but they do not become “easy to win.”
This week’s mystery of the week
To go along with my treatment of the passive vs. active investing debate last week (Actively Clarifying What Has Actively Become Silly), a question is in order, and I actually do not have the answer … For those arguing that passive ETF investing is the inevitable way of the future, why are the publicly traded companies who make ETF funds among the worst performers in the market this year? Is the market seeing something else? If so, is that happening passively or actively? If a tree falls in the forest … You get the idea.
Dollar rally slowing
It is our belief that the U.S. dollar rally, the major short-term source of disruption in emerging markets the last 4 or 5 months, is overdone. The currency devaluations we have seen in certain emerging markets serve as a check on U.S. inflation. $500 billion of dollar repatriation to the United States is done, slowing the levels of “dollar shortages” in other countries (and allowing the additional repatriation to be adequately priced in and planned for). Realities of U.S. budget deficits do not allow for much-continued strength in the dollar unless markets believed there was some plan to limit those deficits (if there is, please let me know what it may be). Only the trade war threat serves as the real obvious catalyst for continued dollar pressures to the upside.
Politics & Money: Beltway Bulls and Bears
- Comment of the Week: The Obama administration believed the Energy sector and Financials sector needed more regulation, and the Technology sector needed little, if any. The new administration believes the exact opposite – that financials and energy were over-regulated, and technology had been getting a free regulatory ride
- 76.4 million people are expected to pay no income tax at all for 2018 under the new tax bill, versus 72.6 million people who did not pay any last year. The top 1% will account for 43% of tax revenue collected, up from 38% last year (1). (Sort of distorts that narrative about the tax bill being a handout for the rich, eh?)
- Speaking of the tax bill, the House Ways & Means Committee released their plans for a 2.0 tax bill this week, though it appears there is no chance it will be taken up before the midterms. The bill includes making a lot of the individual cuts of the prior plan permanent and allows for a special kind of savings account that would allow for no tax on capital gains. It’s all a wait and see at this point.
Chart of the Week
I have written for many years about the vast ramifications of our nation’s under-funded municipal pensions. Ironically, many investors have assumed the ramifications will damage municipal bond values (they have not), instead of seeing it as a threat to services, governance, and public policy. I heard famed hedge fund manager, Ray Dalio, speak this week about the looming pension issue and it brought to mind this reality. At the end of the day, our state pension funds assume too high of a return, earn too little of a return, and fund too little of what they owe regardless.
Quote of the Week
“What we learn from history, is that we do not learn from history.”
~ Benjamin Disraeli
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I hope everyone’s fall season is off to a great start. It has been a painfully busy, but productive, week in New York City and I am so glad my wife got to be with me for most of the week. I head back to Southern California late Friday night and will look forward to spending the next four weeks at home base.
Our thoughts and prayers are with everyone in harms way from Hurricane Florence.
And may the ten-year anniversary of the fall of Lehman Brothers be the reminder that it should be – that good financial decisions matter, and so do bad ones. That the financial decisions some make do carry systemic and contagious consequences. And that one’s behavior in a crisis, or a euphoria, represents the great determination of one’s financial health. To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
(1) Tax Policy Center, Sept. 7, 2018, Marketwatch
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.
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