Dividend Café

The Fed's Stocking Full of Coal - Dec. 21, 2018


Dear Valued Clients and Friends,

The markets resumed high levels of volatility this week, and on Wednesday as the Fed went forward with their fourth interest rate hike this year, the market went up 350 points, then went down over 500 points, then came back a couple hundred points, all in an hour or so, as traders, computers, panickers, and opportunists all did what they do to a market (I know which one I want to be out of those actors).  The sentiment in the markets is decidedly negative right now, and I believe you will find this week’s trip into the Dividend Café to be a rewarding experience in terms of understanding the Fed, the lay of the land, the truly uncommon aspects of 2018, and so much more.  This is one you won’t want to miss!

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How crazy is this year?

There are still five market days left in 2018, so who knows what could happen with interest rates or stocks between now and the close of markets on December 31, but as of right now, stocks are comfortable into negative territory on the year, and the total return of a 10-year Treasury bond is as well (though less so than it was a month or so ago).  If the full year total return on both the S&P and the Treasury bond ends up being negative for 2018, it will be the first time that has happened since 1969 …  effectively FIFTY years ago!  I will wait for markets to close the year to really analyze final data, but from small cap to real estate to commodities to international markets to global bonds to domestic bonds etc., it has simply not been a year where many asset classes provided an escape from either “flat” conditions, or negative ones.  And worse, even the “flat” conditions were anything but throughout the year (i.e. high volatility just to end flat or slightly negative).

The one exception …

Alternatives.  Obviously, it depends on what alternative, and at what weighting, etc., but the oft-derided world of hedge funds and private equity this year will post their performance relative to high beta risk assets (stocks and bonds) in many years.  And on an absolute basis, our Alternatives will be the only asset class delivering attractive 2018 returns.

What we learned from the Fed this week

The Fed did increase rates up to a 2.25%-2.5% Fed funds rate, and this was the fourth rate hike of 2018.  The Fed Futures market had been pricing in a 75% chance or so of this happening, so it wasn’t a surprise to markets.  They also reiterated their intention to continue reducing their own balance sheet by about $50 billion per month.  The Fed mildly reduced their expectation for economic growth in 2019, which really means they restored their expectation to where their expectations were in June of this year.  They had previously forecast three rate hikes for next year, but are now forecasting two hikes (again, at a quarter point each).  The thing holding the Fed up and confusing their messaging is not President Trump’s jawboning; it is their fear of inverting the yield curve.  For the Fed to confidently see their policy normalization and tightening through, they need to see the long end of the curve increase (a steepening curve), as continued normalization with a curve this flat increases the risk of inversion.  But the long end of the curve has not cooperated at all, and the Fed is choosing to try and control the curve (good luck) vs. letting the curve inform them.

Now, I am sure you are wondering – what does that mean?  The issue is the signal embedded in interest rates.  On one hand is the long-end of the curve – meaning, longer-term bonds, that are settling at very low yields and do not believe inflationary growth will eat away at future opportunity – and on the other hand is the short-end of the curve, responding to the reality of a tighter Federal Reserve taking liquidity out of the system.  If all maturities of interest rates were moving up in tandem, it would be a different situation; but in this case, we have short-dated bonds rising while longer bonds are not only “not rising” – they have come lower.  The signals of this flat yield curve freezes the Fed, which believes it sees data that warrants tighter policy, and rightly believes they do not want to be caught without a policy tool at the next economic slowdown (hence the rush to get to normal), and yet has to respond to reality.

So where are we??

There is no doubt that the Fed was “more dovish” this week, but perhaps the market did not find them dovish enough.  Here are the comments I would offer you on the Fed’s comments:

(1) They did not make reference to the housing market, which is clearly slowing down (perhaps dramatically)

(2) They said “inflation expectations are little changed,” and yet oil prices have dropped 35%.  If that is not disinflationary, I do not know what is

(3) They referenced the potential need for “still further gradual increases”

So I do not know if 2019 will produce one, two, or three more rate hikes (or zero).  I do know that the market wanted to hear that it will be on the lower end of that range, and they came away with a reasonably mixed message that facilitates greater uncertainty.  I believe that 2019 is shaping up to be very similar to 2016, and that late 2018 is shaping up much the way late 2015 did.  The Fed then was forecasting a new round of monetary tightening, oil was dropping, and China was weak.  The similarity now is remarkable.

* Strategas Research, December 19, 2018

Is the Fed at risk of a policy mistake, by tightening more than economic conditions warrant?  Certainly.  But have they done so yet?  No.  The bad news is that uncertainty has to persist because the Fed did not do capital markets the favor this week of spelling out clear 2019 dovishness.  But the fact of the matter is that there is a strong likelihood that the market is over-pricing what real tightening will take place, and that in real 2019 conditions, the severe liquidity reduction in the system the Fed has facilitated will go a different direction.

Oh what a tangled web we weave with central bank intervention.

The secret sauce in the Fed’s actions and words

I would offer a somewhat nuanced perspective that no comment more disturbed markets Wednesday than Chairman Powell’s comment that “the runoff of the balance sheet has been smooth and served its purpose; I don’t see us changing that.” It is much easier to focus on the basic interest rate policy because it is easy to explain. The Fed’s balance sheet, however, is complicated and not easy dinner-time conversation, let alone click bait for the media.  But if the major issue compressing economic growth on the monetary front (and creating fears of earnings compression) is limited dollar liquidity, the fact of the matter is that the Fed’s “quantitative tightening” (which is the best term for it, as all it is is quite literally the reversal of “quantitative easing” which  became a household term post-crisis) is far more significant than the short-term interest rate.

What I am referring to is academic and mechanical, but important.  The Fed bought almost $4 trillion of Treasury and mortgage bonds with money that did not exist from 2009-2015 (QE 1, 2, and 3).  They are NOT now selling those bonds; but when they mature, rather than reinvesting the proceeds, they are letting them “roll off” (a backdoor way of removing excess reserves from the system, or put differently, reducing liquidity in the economy).

I do not know if the Fed will stick to its statement yesterday that they are unfazed in their intentions to continue tightening (roughly $50 billion per month).  Past Fed chairmen blinked several times when it came to (a) Not doing a further Quantitative Easing (2010, again 2011); (b) The timing of tapering off Quantitative Easing (2013); (c) The rate of reducing that balance sheet (2016).  So the precedent has been wavering on this policy lever in favor of dovishness, which may be why markets particularly disliked Chairman Powell’s apparent resolve to stay this course.

The Advice and Insights podcast is dedicated to this topic, by the way.

Asset allocation rears its beautiful head

What can one say about a 14% market drop from peak-to-trough in the broad U.S. equity index?  Well, U.S. Treasury bonds have risen in value about 5% in that same period, restoring for the first time all year the more conventional inverse relationship between stocks and bonds.  As I mentioned earlier, alternatives have largely done well in this period, certainly on a relative basis, and often on an absolute basis as well.

This chart will mean a lot more to me when the year officially ends, but who would have guessed earlier in the year that all of a sudden with one week left in the year bank loans, muni bonds, mortgage bonds, and treasuries would all be in slight positive territory, leading the pack, with the S&P at the bottom?  And take heed!  The same people who are now saying “why own stocks?” were the ones earlier in the year saying “why own bonds?”  Asset allocation driven by what is most popular or sentimentally strong in the recent past is not asset allocation; it is destruction waiting to happen.  Sensible, professional, adult, responsible asset allocation is driven by the humility of not knowing which asset class will pop next, and the acknowledgment that various asset classes contain particular blends of risk and reward outcomes.

The bright side

Equity investors should be entering 2019 with these facts front-and-center:

  • There are few fundamentals investors can point to that justify the recent sell-off.  The sentiment’s southbound turn is explained in the two-headed monster of the trade war and Fed tightening, but fundamentally, until proven otherwise, economic growth is continuing to expand, and corporate earnings are incredibly robust while balance sheets are flush with cash.  A fear-driven run on equities is categorically different than a reversal of fundamental strength.  That is unhelpful when one cannot time the reversion to fundamentals from fear, but history has not been kind to those who capitulate to the emotions of other investors vs. the fundamentals of the market or their individual holdings.
  • Oil prices are inherently unpredictable, but on a supply-demand basis, not to mention other geopolitical factors, are likely near a bottom.  Oil prices do not need to be high to help the economy; in fact, that can be a significant negative as they are an input cost for both consumers and producers.  However, they do need to be not collapsing, as that creates distress in the bond market, for banks, for capital expenditures, and for global growth sentiment.  Goldilocks is likely about $50-60/barrel, where fear of $35 is not on the table, but consumers are not absorbing $75.
  • It is simply unacceptable to say (February) that equity prices are doomed because of rising rates, and then to say (December) that equity prices are doomed because of dropping bond rates …  Bond yields have rolled over.  This will have an impact on dollar liquidity, debt service, and more.
  • Credit has not rolled over.  Bond spreads have widened but absolutely not blown out.  Some aspects have actually come in with this last leg of equity sell-off.  For there to be a sustainable drop into a bear market in equities, there needs to be a capitulation in credit.  High Yield bond spreads can’t stay tight if the world is ending.  The ratio between credit drop and equity drop is way off kilter.
  • Most important of all – no part of the recent equity market drop has been related to underlying earnings dropping; it has entirely been about equity valuations dropping.  P/E ratios now sit beneath historical averages; not above them.

Cost of capital vs. return on capital

The section beneath this one will make the case that the very metric I am applying to the U.S. in this section does not bode well for Europe, but the fact of the matter is that the return on capital in our corporate economy is far higher than the cost of capital, and we simply do not have recessions when that is the case.  All of these things have to be monitored, for when the facts change, the application changes.  But this sentiment-driven sell-off is not recessionary, and that cannot be said emphatically enough.

My darkhorse for concern isn’t that dark

The easiest-to-forget truism when it comes to understanding markets is that it is generally things that are not expected or foreseen which do substantive damage to markets, not the things everyone is talking about.  In other words, headline items can cause a dip, but not usually a sustainable one, as markets price in what it is that the whole world is talking about; but when more substantive moves to the downside come, they are almost always driven by the things people were not talking about.

I remain convinced that a potential overreach by the Fed is a real risk, as is the lack of satisfying conclusion to this trade war.  However, it behooves us to not only stay focused on what everyone is focused on, but also on darkhorse candidates for market disruption which are not commanding the attention of market pundits or actors – and at the top of that list right now is European banking health.

The chart above looks messy, but points to a simple reality: The European bank sector is distressed, and has received CPR several times over the last decade in the form of monetary policy intervention (The Fed, Draghi/ECB, global coordination).  Italy is ground zero in Europe right now for the relationship between European Union members and the commission …  The divide between the populists and the ruling class is widening …  And should things worsen in Italy, it hardly seems likely that the damage would be limited to Italy, but would spread to vulnerable banks throughout the European continent.

No one can predict how things will play out, and if they could it would move Europe from a “seen” risk to an “unseen” one.  But with that said, this is something that must be understood in weighing global risk asset valuations, and the specifics of asset allocation.

Uncertainty vs. bad news

How severe is the elevated volatility right now?  Out of 55 trading days this quarter so far, 17 of them have seen – not intra-day 100+ point swings, but intra-day 500+ point swings!  Put differently, 30% of the time this quarter, the market has gone up or down over 500 points within the same 6.5-hour trading day.  One week saw five days in a row of it.  Several days have had nearly thousand point moves.  Such high volatility becomes a self-fulfilling prophecy as the gyrations of it all weigh on investor sentiment.  Bad news can create a sell-off, but only uncertainty can create such volatility.

Is this the highest volatility ever?

And now for the sobering reality – it isn’t even close.  Now, the December volatility (and much of the volatility in Q4) has been higher than the norm, of course.  But on the year, the annualized daily volatility of the market is 16.5%, meaning, it is at the 66th percentile over the last 100 years.  In other words – not even the top half of average annualized daily volatility (again, this is for all of 2018, not just Q4).  The fact of the matter is that the average volatility of 2018 will be way, way higher than 2017, which was the lowest ever, but not very high by historical averages.  And as for the total year downturn, I will wait to see the final number to comment.  As I said earlier in the Cafe, the story of 2018 is not the somewhat muted stock market downturn; it is the fact that every asset class one could find joined the market in such a downturn.

Politics & Money: Beltway Bulls and Bears

  • I don’t think the hubbub around the conditional resolution to keep the government open, or the fight over funding for the border wall, carries much market ramifications whatsoever (though I’m sure it carries some political significance). Markets have never blinked at the media’s hysteria around “government shutdown.” I’ll let you speculate as to why that may be.

Chart of the Week

When one looks at the history of market multiples, and the bandwidth of Price-to-Earnings ratios we have seen for a couple decades, one can fairly wonder if we will overshoot the downside of valuation, but one cannot miss seeing this recent re-pricing as a chance to buy attractive companies with sustainable revenues, earnings, and return of cash to shareholders at even lower valuations.

* Strategas Research, Qualitative Analysis, December 20, 2018

Quote of the Week

“No warning can save a people determined to grow suddenly rich.”

~ Lord Overstone

* * *
I will leave it there for the week with a repeated invitation to reach out with any questions you may have.  Our planning into 2019 regarding asset allocation decisions and portfolio positioning will be well-communicated.  We are targeting significant rebalancing around January 14.  The basic allocation posture will be explained and defended, and will be appropriately balanced to our view of markets and conditions going forward.  In the meantime, the sentiment is too negative to intelligently discern any coherence in market behavior.  It is hard to believe buyers are coming back en masse in the next week or two.  So be ready for Christmas volatility on light volume, New Year’s volatility on light volume, and then a launch to 2019.  And I assure you, our views going into 2019 are getting more comprehensive by the day.

We are here for you any time with any concerns about this market distress.  We also are doing and have done the right thing for our clients before and during this period, aligning client goals, needs, and realities with their portfolio investments.  To that end we work.  The permanent reality of market volatility does not change that.

Merry Christmas to you and yours.

With regards,


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.

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