Dividend Café

The Unwarranted Fed Fretting - Sept. 28, 2018


Dear Valued Clients and Friends,

Q3 is wrapping up or done by the time you are reading this.  This means we enter my favorite quarter of the year, and it means there is less time for markets to surprise us within this calendar year.  I really go to great lengths in this week’s Dividend Café to defend our thesis that the extension of this economic expansion and market advance is justified by the increase in business investment we are seeing around the country.

Two new posts went up this week in my series of short articles about the financial crisis, and tomorrow (Saturday) marks the ten-year anniversary of Sept. 29, 2008 (the infamous Monday drop of 777 points in the Dow the day the House voted down the TARP legislation).  I hope you are enjoying the series, and next week I will bring it all to a conclusion with a really important summary of what it all means to each of us, here and now.

In the meantime, let’s jump into the Dividend Café!

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So how is the economy again?

I want to show you a few charts from my friends at Strategas Research to make a few points on CAPEX, the key ingredient in driving higher productivity in this economy:

Note first the increase in business equipment the last couple of years, a key to driving the production that will be needed for a capex renaissance:

Note how high our capacity utilization has risen in terms of industrial production, an indicator suggesting near full capacity!

Now look at capital goods orders the last couple of years:

And finally, note how industrial production has risen with real GDP growth, and in fact, may indicate that real GDP growth has a ways to go still!!

I can only say that these metrics may not be as exciting as the monthly jobs report or the quarterly GDP report, but these types of readings tell us if we are right about our forecast on capex and the boom that will be necessary to sustain this economic expansion and market.  It is hard to interpret any of this pessimistically.

And the Fed’s thoughts on all this?

See my very next paragraph on why a general narrative needs to be blown up, but for those who are sitting on pins and needles wishing the Fed would stop raising rates, it is nearly impossible to believe the Fed would be swayed to delay tightening what is still an accommodative monetary policy when they see unemployment at 3.8%, and capacity utilization basically full.  The industrial side of the economy matters, too, and the Fed believes it is full steam ahead.

Setting this economy, market, Fed straight

One of the things that you are asked to believe in this current environment is that the best thing to root for is (a) Strong economic performance, and (b) A Fed that stops raising rates and normalizing monetary policy.  The pedestrian narrative is that the Fed helps investors by distorting the natural price of money and that there can be a sort of hangover-less drinking binge if the Fed would just stay out of the way.

Of course, I agree that strong economic performance is to be desired, and I agree we are seeing it.  But while I understand short-termism as much as the next guy, it is factually inaccurate that Fed-induced distortions in the marketplace are an ipso facto positive for investors.  Brutally inaccurate.  Markets respond to clarity and certainty.  Delaying the inevitable adds to uncertainty.  A distorted price signal creates a bad investment.  It might feel good for a little while (or not), but “in the end the way of excessively distorted markets is bubbles.” And you know what happens to bubbles.

My comments are not specific to any actual Fed decision here and now that they ought to make or ought not to make.  My comments are to the general, and I believe destructive, narrative – that a permanently accommodative Fed is what we ought to really wish for.  It just isn’t so.

I’m old enough to remember this spring

Just a few months ago, the great weight on markets (stock and bond markets) was the threat of impending inflation (allegedly).  As we enter the fourth quarter, gold is down over 8% this year and is 35% down from its high earlier this decade.

The consolation for gold as the stable alternative to the U.S. dollar (which is up 3% on a trade-weighted basis this year) is that bitcoin, the other “alternative currency,” is down 55% on the year, making gold look positively stable.

A Post-Crisis Milestone Happened this Week and No One Noticed

With the Fed’s increase of the fed funds interest rate this week by another 25 basis points (+0.25%), to an effective 2.25% level, we now have a positive real interest rate for the first time since the Fed’s crisis-era monetary policy began ten years ago.  With a 2% inflation rate (as measured by the Personal Consumption Expenditure index – the PCE – long known to be the Fed’s favorite measure of inflation) – and a fed funds rate just higher than that – this represents the first time that the real rate is not actually negative!

Why have higher rates not hurt the stock market?

There are a few things to say about this.  Most importantly, the analysis that said higher rates would hurt the stock market was always cheap and shallow analysis.  There was little history on its side and little awareness of how markets actually work (as discounting mechanisms) behind it.  But the fact of the matter is that the increase in rates has, thus far, been quite slow and gradual.  One stunning factoid I was reminded of this week: the ten-year Treasury yield has increased .5% this full year; it increased by 1.3% in just a few months in 2013 when the taper tantrum happened.  The slow pace and low magnitude of this rate move has limited impact on risk markets.

Another factor to not forget – corporate bond yields have not moved at the same rate as treasury yields.  It is always the relationship between credit rates and treasury rates – not the absolute rates themselves – that tells us the most about growth, confidence, etc.  The return on invested capital in the private sector has continued to exceed the borrowing costs, which has facilitated more investment and growth.

Who you calling cheap?

When one looks at what can be considered cheap in this market, it is helpful to not merely look at market performance in this cycle but to normalize that performance for historical valuations (assets are mean-reverting instruments, always and forever).  Energy and Telecom and Financials are the only sectors where normalized for historical average valuations, they have not moved up since the financial crisis as normal valuations would have called for.  The two sectors most ahead of their normalized valuations since the crisis?  Technology and Consumer Discretionary.

* JP Morgan Asset Management, Market Recap, Q2, 2018

Speaking of oil and energy

WTI Crude Oil was sitting near $50 a year ago and is sitting between $70-$75 today – a ~50% increase in 12 calendar months.  The energy sector’s performance in that same 12 months?  +12.85%

By the way, speculative net long positions in the oil futures market are down 30% from the beginning of this year.  World oil markets are losing 2 million barrels per day of production from the sanctions on Iran and the lack of output in Venezuela.  With supply and demand more in equilibrium now than any time since 2014, various disruptions to supply or increased in demand should have a higher impact than they have at any time in years.  There is more upside risk than downside at this stage, though both exist, and commodity price speculation is a fool’s errand.

What ends this bull market in stocks?

At some point in time, I believe it will be the Fed.  Eventually, the tightening efforts of the central bank to reverse the easing efforts of the central bank find that magic spot and end the business cycle in which we find ourselves.  But keep this in mind when you hear forecasts of what the Fed will be doing in the future – there is not a single Federal Reserve governor who, right now, knows what they will be doing in six months, let alone one year or longer.  Not one.  And if they do not know, I assure you, the people forecasting what they will be doing do not know either.

Tax reform, use of cash, capex, and dividends

The pleasant surprise of how corporate America has used tax reform’s increased cash flow has been capex – up 22.4% year-over-year.  Stock buybacks are up 51% but were projected to be.  And how does the 9.6% increase in dividends from the S&P 500 (year over year) size up?  Because the companies we own have increased their dividends year-over-year 14.8%, the relative increase in income vs. the rest of the market is a big value for us.  Stock buybacks are what they are, but capex and dividend growth get us going – and in those categories tax reform has been an A+.

* JP Morgan Asset Management, Weekly Market Recap, Sept. 24, 2018

Politics & Money: Beltway Bulls and Bears

  • The way the trade war has escalated with China is so dramatic and theoretically severe that it is having the paradoxical impact of not being believed.  In other words, the impact would be so large (25% on $500 billion of imports), that the market has basically said, “yeah right, like this would ever really happen!”  The markets, of course, could be wrong, but it is a reasonable response to the present state of this discussion.
  • More and more people are wondering if the market will suffer should the Democrats re-take the House in the midterm elections.  If they take the House, which until last week I would have guessed they were going to, but now I am not so sure, they still will not have the Senate, and they obviously will still not have the White House.  And as you know, it takes the President, the Senate, and the House for a bill to become a law.  Furthermore, the most market-impacting “stuff” that has happened since Trump became President has been on the executive branch level (de-regulatory measures within executive branch purview), and not impacted by the change of legislature.  The markets have any number of things, always, that can cause them to rally up, or to fall down ….  But the midterm elections happen to be the least of my concerns (as far as market impact).
  • Is the theme we have on increased political risk in the “new tech” sector moving from bluster and rhetoric to potential action?  The Federal Trade Commission is launching a study on various tech firms competitiveness, and the executive branch itself is directly agency prodding in these things.  It is hard to see how it all ends well, or at least without impact to valuation.

Chart of the Week

For those wondering how President Trump seems to still have the upper hand in dealing with China on this trade war mess, look no further than this chart here.  If the S&P 500 line was even flat, let alone downward sloping, it would dramatically limit his leverage.  But the forward growth of the stock market and the growing spread between our two respective stock markets have emboldened the administration to push forward with more protectionist rhetoric and policy, whether actual policy or threats of policy.

* Strategas Research, Policy Outlook, Sept. 24, 2018, p. 4

P.S. – How does China offset the impact to its economy on these tariffs?  They do exactly what they have been doing – they weaken their currency.  Since this escapade started there has been a 10% tariff (on average) implemented on half of the exports from China to the U.S.  And how much has the renminbi depreciated against the dollar?  10%.

Quote of the Week

“Surprise is the mother of all panic”

~ Nick Murray

* * *
We will have more summary of Q3 action in various markets and sectors next week.  It was a robust quarter for risk assets in the United States, and not so much for global risk assets.  Q4 will likely be more about Q3 corporate profit results than Fed action or midterm elections, but all of it will be in the milieu market watchers pay attention to.  In the meantime, enjoy this last weekend of September, and bring on the autumn season …  Did I mention this is my favorite time of year?

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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