Dividend Café

The Bad News of Good News - May 4, 2018


Dear Valued Clients and Friends,

Another week into earnings season, another week of phenomenal results, and another week of the market experiencing some hesitation and concern.  As of press time (and we know that the delta between my press time and your reading time can create all sorts of market movement), markets were down on the week, but in the face of some pretty robust company results.  That tension – how markets are not responding more favorably to such positive earnings results – is the primary source of conversation amongst market participants this week.  We’re going to talk asset allocation, fixed income, inflation, and investor behavior this week, so join us in the Dividend Café!

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A three-act play

I see the volatility since late January as very much non-monolithic, and in fact divide it into three acts: The first act was the post wage-growth scare that led to a VIX spike and technical market breakdown.  It did not last long.  The second was the on-again, off-again “Trump/trade/tariff” debacle of late February and much of March.  This story persists in the background, elevating skittishness for sure, but has subsided around market hopes post-Kudlow that the President will not follow through on some outlandish threats.  And the third act that we have been in the last couple of weeks centers around bond yield movements north and the re-pricing of equities due to bond and rate conditions.  As we have said and elaborated on more below, this is very much tied to inflationary expectations too.  Ironically, gold has sold off substantially and the dollar rallied the last two weeks as markets allegedly fear more lasting inflation.  Markets don’t need reasons to do what markets do in one-week and one-month hiccups, but in this case, the reasons are multiple and have been sequential.  What will the fourth act be?  For me and my clients, it will be the disciplined maintenance of a plan rooted in fundamental dividend growth – devoid of noise.

Thoughtful asset allocation

The whole point of asset allocation is what, exactly?  To create a more optimal overall experience for an investor in terms of both the return and the risk taken to generate it, by mixing different asset classes together that, in their relation to one another, help create a better risk-adjusted outcome.  At the heart of this belief and most common implementation is the idea that bonds often buffer the volatility of stocks (a belief well-verified by history).  But from a thoughtfulness standpoint, asset allocators may very well find bonds an imperfect hedge against stock volatility in 2018.  When deflationary pressures hurt stocks, bonds generally move much higher, creating the offsetting zig for the stock market zag asset allocators love.  But if inflationary pressures hurt stocks, those same interest rate pressures are likely to hurt bonds too, in the short term.  Does this diminish our commitment to asset allocation and the pursuit of optimal asset alignment towards the objective of a better risk-adjusted return?  Not in the least!  But it does cause us to believe that the role of alternatives may be more important in a thoughtful asset allocation right now.  Moderating equity volatility will perhaps be better optimized from alternatives than bonds in 2018.

Deconstructing economic growth

The GDP number for Q1 was released last Friday, and the result was real GDP growth of 2.3%.  The consensus expectation was for 1.8%.  This is a big deal.  I have taken the liberty of highlighting the last few Q1’s, so you can see the standard trend of Q1 results relative to the rest of the year:

* Commerce Department, WSJ, April 27, 2018

2015 is an exception for a few years, but if the pick-up into Q2, 3, 4 goes the way that the last couple years have gone, an annualized rate of 3%+ is very likely. 

Under the hood of this number, the pessimists are saying, “look, the consumer is slowing.”  But the business investment piece is what has been missing from GDP growth, and it was positively on fire.  It was business investment led by capital goods orders that drove a good number.  Commercial construction, technology, software up 6.1% !!!!  Structural spending (capex) up over 12% !!!  This is the story!

(By the way – the only sign of a drop???  Dishwashers and cars!!!  Down 3.3% – the worst drop since 2009!!  Can someone say TARIFFS?)

I believe the tax reform stimulus, deregulatory efforts, and renewed business confidence will get us above 3%, and only unforced errors will undermine that. 

Pointing out the obvious

Yes, earnings growth has been remarkable this quarter (both in year-over-year growth and relative to the expectations that had been re-formulated after tax reform).  And yes, that very tax reform is behind much of the year-over-year improvement.  But I do hope it goes without saying that taxes are only paid on profits, so while tax reform may have added to the earnings growth, it can’t be the determinant factor in revenue growth (or any factor whatsoever).  It is the top-line revenue increase that is most encouraging this quarter, and that has been completely organic.

What to do about the rising dollar!

It is surreal that the argument that dollar strength is a secular negative for stocks still has media credibility.  As I have written and presented for years now, there is no way around the historical reality – the relationship between the dollar and stocks in a whole host of short-term time horizons is hyper non-correlated (zigs and zags and no clarity on what one does to the other), and in the long term, secular currency strength out of a strong economy is bullish for stocks, not bearish (i.e. see: the 1980’s, and, the 1990’s).  That said, short-term, we expect the current market dynamics in trading windows to inversely trade to a country’s currency for a variety of reasons.  This is primarily because the dollar is moving around longer-term interest rates, and longer-term interest rates are in a phase of re-pricing equities as we discussed last week.  The problem with formulating an investment policy around this is, well, it is transitory – meaning, it is true until it isn’t.  There is not a secular theme out of such a move, and it is the textbook definition of “noise.”

Have we seen this movie before?

Higher inflation expectations have caused interest rates to move up.  We know this.  The ten-year bond yield is up 90 basis points in eight months.  TIP yields are up 50 basis points.  But in 2013, we saw the ten-year rise 130 basis points and TIPS a whopping 170 basis points.  Stocks ended up 2013 with a 30% return, and enjoyed a modestly positive move in 2014 and 2015 as well, and then robust movement in 2016 and 2017.  In other words, the key issue will be whether or not we truly face inflationary pressures, and how deep and wide they prove to be.  The chatter now increases volatility, no doubt (see summer, 2013), but it does not help us forecast the years ahead.  If it did, the next scenes from the movie have historically gone quite well for equity investors.

Inflating the reality of inflation

We have seen a 20-year period in inflation unlike any other in history.  The period since 1997 makes inflation look like a banana republic in the 1970’s if we are only looking at health care and college expense.  There is more “normal” inflation in housing, wages, and food (“normal” does not mean “benign”).  And there have been deflationary forces in technology.  Understanding the “sum” of inflation is important, but so is understanding the “parts.”

Is there safety in Europe?

Perhaps the thing to do with market volatility returning to the U.S. markets is looking across the pond to Europe for a better risk/reward opportunity …  The argument most Euro-bulls often make is that the U.S. recovery has been more robust post-crisis than Europe so it is “Europe’s turn.”  I have never found that argument particularly compelling.  Geographical zones do not get “turns” – what drives markets are the entirety of actual conditions, fundamental, corporate, monetary, fiscal, geopolitical, and more.  The reality is that Europe’s lag of the U.S. has been highly rational given a slew of conditions.  So where are we now?  The Eurozone’s so-called recovery has cooled, was never that warm to begin with, and has come and maybe gone without any of the structural reforms that were desperately needed.

The case for pipelines

Why do we invest in oil and gas pipelines?  Because they pay attractive dividends and grow those dividends as volumes of oil and gas running through them increase.  Why do we need more pipelines, and more oil and gas running through them?  Because it cost 10x as much to transport oil by truck as it does a pipeline (1), and trucks can only carry 200 barrels of oil, whereas pipelines can move 600,000 barrels per day.  Oh, and there is the whole environmental argument, too!  A higher percentage of the oil and gas moving around North America needs to be moved by pipeline, and to do that we need more pipelines.  And this volume increase leads to more distributable cash flows.  That is the heart of the matter.

The fatal error

I heard a speech the other day from the founder of a huge low-cost provider of index funds, and his underlying point was that costs and fees are the major factors in long-term performance.  There is something appealing to the idea that all we have to do is find the lowest cost [something], and all will be well in the world.  The thesis is, of course, preposterous.  Investor behavior has derailed more successful financial outcomes than every other problem put together since the beginning of capital.  Investors fare well to be cost-conscious, and to make sure they receive value for what they are paying in their investment experience (I might add as a long-time drum-banger for the fiduciary movement, that investors have a much better chance of making sure they receive value for what they are paying when they actually know the truth as to what they are paying).  But destructive decisions with low-cost investments will save no one.  All axes to grind that the index industry has notwithstanding, fees that pay for themselves many times over through value-added are never a problem; an investor’s propensity to temperamental errors that can be fatal.  So to that end, we work.

Chart of the Week

There was a historically unique experience since much of the post-financial crisis time wherein the dividend yield on the S&P 500 itself has been higher than the 10-year treasury bond yield, let alone cash and short-term bond instruments.  That anomaly has ended but has important ramifications for income-driven and valuation-sensitive investors.  The 10-year bond yield is now higher than the S&P 500 by a full percent, and as you can see in this week’s chart of the week, short-term instruments have seen their yields rise too (which is the historical norm).  This intensifies the primacy of dividend growth – and higher dividend yield. Active selection of sustainable growth of income is the best defense against this “old normal.”  The free ride for indexers is over.

Quote of the Week

“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.”

~ Arthur Schopenhauer

* * *
It is perhaps quite frustrating to many investors to see the “three-act” volatility of the last few months (see the first paragraph of this Dividend Café).  I don’t share that frustration but I am keenly aware of where it comes from.  The present “marks” of my investment values do not matter to me or my clients for the simple reason that I am not selling those investments.  But again, investor psychology and behavior are what they are.  But I will say this – the noise of the present market is not a lasting threat to investor outcomes, and even though many are going to need hindsight to know this, some tremendous opportunities are being offered to investors who like such a thing …  At The Bahnsen Group, we view it our fiduciary responsibility to embrace – not reject – opportunity.  So to that end, we work.

With regards,


David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner

The Bahnsen Group

(1) StatsCan, 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.

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