It is rare for me to say this, but if every one of you opened this week’s Dividend Café, and scrolled straight to the bottom just to read the “Chart of the Week,” I would be happy. Of course I think there is a lot of good and important stuff here besides that, but truthfully the lesson in that section near the bottom of this week’s Dividend Café is among the most important things we have ever penned. So open away, read away, and digest. Off we go…
You saw that correctly!
Yes, President Trump gave a speech Tuesday night where critics and pundits all responded favorably, commenting positively on his demeanor, tone, and presidential sound and feel. And yes, the market was up over 300 points on Wednesday, bringing the Dow to over 21,000 …
Did he back track on China-protectionism? Not really. Did he backtrack on Mexico-protectionism? No, not really. And in fact there was a fair amount of economic nationalism and anti-trade particulars that were rhetorically appealing, but potentially problematic for economic growth. And, the speech lacked much specificity around plans for corporate tax reform, though the commitment to see it through was evident and is unquestioned by the markets at this point. He didn’t specifically embrace the Border Adjustment Tax but he made vague references towards supporting some of what it sets out to do. He gave more info about his vision for FDA reform which offset fear of drug price discussion. His talk of infrastructure spending focused on energy (private sector), and the other parts had enough ambiguity around them as to not fear deficit blowouts. His section on ObamaCare repeal was not remotely ambiguous, and has embedded tax reduction in it the market loves. All in all, the markets loved the speech, and I will add that I believe they especially loved the tone and demeanor (think election night and the market move the next day).
How dare you call me that? Wait, I am that!
One of the most allegedly anti-intellectual things one can be called these days in the echelons of investment finance is a “perma-bull,” for it conjures up an image of some rose-colored glasses Pollyanna who cannot see the complex and nuanced realities of black swans and dangerous markets. Really smart people, if you believe this punditry image, write blogs claiming stocks will crash or are being pumped up by “globalist” or “corporatist” or some sort of diabolical force. Interestingly, this wicked smart crew of stock market skeptics has over the years accused hedge funds of manipulating stocks down, and also of manipulating them up. Oh the teamwork that must be involved by these masters of the universe! It is a sociological reality I accepted very early in my career that one will always SOUND smarter to pontificate on negativity. However, if “smarts” are determined by actual investment results and not verbosity and pretentiousness, let’s just say that I wouldn’t recommend the perma-bears contrast IQ scores with the perma-bulls. In reality, no highly regarded “perma-bull” would ever claim that markets are not subject to intense periods of distress and challenge. Rather, they would embrace those periods for what they have always been since the beginning of market history – opportunities to acquire more shares of innovative profit-making enterprises at lower prices. History is on the side of the bulls, long term. The real intelligentsia knows this.
Everything has just been so good I can’t even remember all the times it was bad
One of the ironies when people talk about how “long in the tooth” this bull market feels is how, well, NOT easy breezy it has actually been! To look at this bull market (which we have surely been in) as one lovely, rosy walk in the garden from March 2009 through March 2017, unchecked and uninterrupted, lacks any semblance of reality. Over an eight year period we did start at 6,500 Dow (low point) and we are now near Dow 21,000 – an incredible gain made somewhat less incredible that before we were at Dow 6,500 we had been at Dow 14,000 pre-crash (so in other words, the first half of this market bull run was making up from where we were pre-crash), but let’s not forget a few other milestones on the way to where we are now in the market:
Greece and the Euro have gone through existential panic mode at least three separate occasions.
“Flash crash” in May 2010 saw the market drop nearly 1,000 points in one day
Summer 2011 saw a full blown 20% drop in the S&P (okay, 19.8%, but who’s counting)
From mid-2014 to mid-2016 the market didn’t move at all start-to-finish – a flat line with volatility all around
In August of 2015 and January 2016 we saw drops of over 10% in each respective month
70% of U.S. stocks were down over 20% in that 2014-2016 period
There have been no shortage of exogenous shocks to the geopolitical system from China depreciation to Japanese negative interest rates to Brexit to Trump to a plethora of terrorist attacks to etc.
So yes, markets sit in a stunning place compared to where they were eight years ago, but the talk of an imminent correction caused by the easy ride investors have had since 2009 is simply not factual.
Tax reform held up at the border (get it?)
What exactly is the basis for skepticism about the administration’s pursuit of tax reform? Why the delay? What could give the markets pause that this will happen in 2017 after all? There really is an adequate, though not sweeping, consensus around income tax reduction, corporate tax reform, and much of the other simplification in Trump’s tax proposal … The hang-up, though, as we have written since before the inauguration is and will likely continue to be the concern around the Border Adjustment Tax. Essentially, this key piece of the House proposal, sometimes endorsed by the President and sometimes not, but largely shunned by the Senate (for now), is a tax on imports coming in (but not exports going out). It is intended to generate a lot of revenue to offset the lost revenue from other tax cuts (the House GOP agenda), and it is intended to promote domestic purchases vs. imports (the President’s agenda). It has a lot of problems – most notably, the fact that retailers hate it – and consumers will hate it even more. We do not like it because we think it will create significant volatility in currency markets, and it is untested and unproven. However, we recognize the possibility that should a Border Adjustment Tax die, rather than let corporate tax reform die with it, policymakers may just replace it with something worse – a border import tariff (with no offset for exports). THAT is a full blown tax on trade, and a real problem. Yes, there are a lot of unknowns right now. If we were forced to bet, we would guess the Border Tax dies, and corporate tax reform still happens, but with a higher rate than planned. However, a high engagement from Trump behind the tax (which he has not yet offered) would change this forecast.
Understanding the utility of Utilities in your portfolio
The commonly repeated mantra is that Utility stocks are down or not participating in the market rally because they are bond proxies and investors expect rising interest rates is fair enough, but not complete. First of all, the spread between utility stock dividend yields and current interest rates is still high enough to absorb increases in interest rates. So beyond the group speak regarding interest rates hurting utilities, there is a simple reality at play: Policy that right now favors utilities by allowing the unlimited deduction on debt interest for massive power projects are likely to go away. We have said repeatedly that corporate tax reform will be really good for business, but that there would be businesses who would prefer the old system of higher rates which they themselves don’t pay (behind various loopholes, deductions, and complexities). Utilities are, generally speaking, not in line to love where corporate tax reform is going.
Lower taxes are always good for investors, except when they are not
History and sound economics do indicate that generally speaking, all else being equal, lower income rates and taxes on investment and productivity make the real value of various investments higher. Incentives increase, and lower capital gain and dividend and income taxes have been good for stocks, bonds, real estate, etc. However, it may be obvious upon further thought but not immediately apparent that there is one investment which, all else being equal, sees its relative value decrease when income tax rates go down: And that is, Tax-Free Municipal Bonds. The obviousness of it is simple – the lower the tax burden an investing taxpayer has, the lower the benefit of the tax-freeness his municipal bonds offer him. So while a high tax bracket person would rather pay 33% in taxes than 40%, the net value of his municipal bonds relative to other taxable alternatives is worth more at a 40% tax rate than 33%. Does this require getting out of muni bonds altogether if these top rates come down? Only if the 33% (or whatever) tax rate doesn’t bother you! Munis will still have their place as long as there is a progressive income tax code; they just happen to be one investment class that paradoxically benefit investors more when the rest of their lives benefit least.
The smart money says the Fed is going to make someone look dumb
The Federal Funds futures market is pricing in a 80% chance of a Fed rate hike by the month of May. That percentage indicates to me that it is has gone from very possible to almost obvious. Our viewpoint is still that the Fed will raise the Fed Funds rate twice this year, by a combined total of 0.5%, which will create a Fed Funds rate of 1% going into 2018. We understand many believe there will be three hikes, but we are still heavily influenced by the “lower for longer” bias that has driven the Fed almost obsessively for nearly a decade. The timing of this first hike is not as important to markets as the level of rates at year-end.
The centrality of central banks is the central question
We are heartened by the decrease of coverage central bank activity has received from the press and punditry class in recent months. Much of that is, of course, due to the intense focus on the new Trump administration and analytical considerations of the fiscal environment (tax policy, legislation, trade, immigration, executive orders, etc.). But we do wonder out loud if Japan’s dud of a trial balloon last year with negative interest rates created a bottom in the primacy of central banks in all things economic. Don’t get me wrong – the “don’t fight the Fed” narrative still has strong prima facie support, but the overall belief that central banks can be ineffective has gained a lot of ground in recent years, and we would add that there is a strong belief that central bank actions can even be damaging.
In defense of defense
When investors position themselves around the belief that there is a need for and likelihood of increased spending on national defense in the short term, are they in the stratosphere of reality? Pretty much, yes, according to the data. Not only did President Trump propose (as expected) a significant increase in spending above budget levels this week, but we can see that the inflation-adjusted budget for defense has come dramatically down in recent years, and is right in a midpoint of the last forty years level despite the extraordinary pick-up in threats around terrorism and such.
* Jones Trading Institutional Services, Feb. 28, 2017
One of these years is not like the other
Last year, through the first two months of 2016, there had been a grand total of zero offerings in the MLP space to raise equity, and by the end of March there were just three, raising just $634 million across the entire sector. This refers to the ability of the sector to raise equity capital in the capital markets. This year, in just two months, there have already been twelve deals, and the capital raised exceeds $4.8 billion.
March’s march to madness
We do have an ECB meeting next week (European Central Bank), the February jobs number coming March 10, the U.S. Federal Reserve meeting (and likely hiking rates) in mid-March, a Dutch election not devoid of controversy, and the official Article 50 trigger at the end of the month launching Britain’s exit from the European Union. So all in all, despite the biggest day of the year in the stock market to launch March, the whole month has a lot on the calendar which will speak to us.
Chart of the Week
We doubt we could have been any more clear in the last few months how much we (a) respect this market rally (understanding exactly where it is coming from and why, as investors price in suddenly accelerating earnings growth and the favorable policy landscape they believe is coming from the Trump administration) and (b) seek to be cautious and prudent recognizing that valuations are stretched, and markets are permanently prone to excesses. Many want to pin us down by asking exactly what we think will happen, and when? We hope clients appreciate our trustworthiness when we refuse to answer that absurd question. Only two kinds of people would even proffer an answer: (1) Liars, (2) Dangerously incompetent advisors. Lucky people may answer and end up getting it right – this time. Those people then multiply the danger stuck to them (emboldened by luck they don’t know it luck, or as Nassim Taleb calls it, those “fooled by randomness.” We don’t answer when the market will turn, or what exactly the market will do next because we do not know, and to pretend we know is to violate our covenant with you to be trustworthy. To think we know would be professional incompetence. Our job is not to know; it is to remind you that you do not know and no one else you know knows. Are there reasons to be cautious and prudent right now? In fact, have we been very slowly and opportunistically building a bit a dry powder cash? Yes, indeed. But hear this too, friends: The consequences of being wrong the other way – of not understanding that “overbought” does not mean “over” – can mean a long, long period of missed returns that could prove fatal. We manage risk through asset allocation. And we understand history, as shown in this week’s Chart of the Week.
Quote of the week:
The bravest are surely those who have the clearest vision of what is before them, glory and danger alike, and yet notwithstanding, go out to meet it.
– Thucydides
Originally published on Dividend Café.