Where “I Bought It For The Dividend” Went Wrong

In early 2017, I warned investors about the “I bought it for the dividend” investment thesis. To wit:

“Company ABC is priced at \$20/share and pays \$1/share in a dividend each year. The dividend yield is 5%, which is calculated by dividing the \$1 cash dividend into the price of the underlying stock.

Here is the important point. You do NOT receive a ‘yield.’

What you DO receive is the \$1/share in cash paid out each year.

Yield is simply a mathematical calculation.

At that time, the article was scoffed at because we were 8-years into an unrelenting bull market where even the most stupid of investments made money.

Unfortunately, the “mean reversion” process has taken hold, which is the point where the investment thesis falls apart.

The Dangers Of “I Bought It For The Dividend”

“I don’t care about the price, I bought it for the yield.”

First of all, let’s clear up something.

In January of 2018, Exxon Mobil, for example, was slated to pay an out an annual dividend of \$3.23, and was priced at roughly \$80/share setting the yield at 4.03%. With the 10-year Treasury trading at 2.89%, the higher yield was certainly attractive.

Assuming an individual bought 100 shares at \$80 in 2018, “income” of \$323 annually would be generated.

Not too shabby.

Fast forward to today with Exxon Mobil trading at roughly \$40/share with a current dividend of \$3.48/share.

Investment Return (-\$4000.00 ) + Dividends of \$323 (Yr 1) and \$343 (Yr 2)  = Net Loss of \$3334

That’s not a good investment.

In just a moment, we will come and revisit this example with a better process.

There is another risk, which occurs during “mean reverting” events, that can leave investors stranded, and financially ruined.

Dividend Loss

When things “go wrong,” as they inevitably do, the “dividend” can, and often does, go away.

• Boeing (BA)
• Marriott (MAR)
• Ford (F)
• Delta (DAL)
• Freeport-McMoRan (FCX)
• Darden (DRI)

These companies, and many others, have all recently cut their dividends after a sharp fall in their stock prices.

I previously posted an article discussing the “Fatal Flaws In Your Financial Plan” which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to grow. The total value of the portfolio will indeed fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends usually go up even when the stock market goes down.

This comment is the basis of the “buy and hold” mentality, and many of the most common investing misconceptions.

Let’s start with the notion that “dividends always increase.”

When a recession/market reversion occurs, the “cash dividends” don’t increase, but the “yield” does as prices collapse. However, your INCOME does NOT increase. There is a risk it will decline as companies cut the dividend or eliminate it.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks; however, leading up to the financial crisis, there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred dot.com bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

While the current market correction fell almost 30% from its recent peak, what we haven’t seen just yet is the majority of dividend cuts still to come.

Naturally, not EVERY company will cut their dividends. But many did, many will, and in quite a few cases, I would expect dividends to be eliminated entirely to protect cash flows and creditors.

As we warned previously:

“Due to the Federal Reserve’s suppression of interest rates since 2009, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief ‘there is no alternative.’ The resulting ‘dividend chase’ has pushed valuations of dividend-yielding companies to excessive levels disregarding underlying fundamental weakness.

As with the ‘Nifty Fifty’ heading into the 1970s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices, and the dividends paid out.”

Love Dividends, Love Capital More

I agree investors should own companies that pay dividends (as it is a significant portion of long-term total returns)it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress.

It is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently:

Dividend cuts are one of the better near-real-time indicators of the relative health of the U.S. economy. While they slightly lag behind the actual state of the economy, dividend cuts represent one of the simplest indicators to track.

In just one week, beginning 16 March 2020, the number of dividend cuts being announced by U.S. firms spiked sharply upward, transforming 2020-Q1 from a quarter where U.S. firms were apparently performing more strongly than they had in the year-ago quarter of 2019-Q1 into one that all-but-confirms that the U.S. has swung into economic contraction.

Not surprisingly, the economic collapse, which will occur over the next couple of quarters, will lead to a massive round of dividend cuts. While investors lost 30%, or more in many cases, of their capital, they will lose the reason they were clinging on to these companies in the first place.

You Can’t Handle It

EVERY investor has a point, when prices fall far enough, regardless of the dividend being paid, they WILL capitulate, and sell the position. This point generally comes when dividends have been cut, and capital destruction has been maximized.

While individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do. As noted just recently is “Missing The 10-Best Days:”

“As Dalbar regularly points out, individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline. In other words, investors regularly suffer from the ‘buy high/sell low’ syndrome.”

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making. In fact, Dalbar is set to release their Investor Report for 2020, and they were kind enough to send me the following graphic for investor performance through 2019. (Pre-Order The Full Report Here)

These differentials in performance can all be directly traced back to two primary factors:

• Psychology
• Lack of capital

Understanding this, it should come as no surprise during market declines, as losses mount, so does the pressure to “avert further losses” by selling. While it is generally believed dividend-yielding stocks offer protection during bear market declines, we warned previously this time could be different:

“The yield chase has manifested itself also in a massive outperformance of ‘dividend-yielding stocks’ over the broad market index. Investors are taking on excessive credit risk which is driving down yields in bonds, and pushing up valuations in traditionally mature companies to stratospheric levels. During historic market corrections, money has traditionally hidden in these ‘mature dividend yielding’ companies. This time, such rotation may be the equivalent of jumping from the ‘frying pan into the fire.’”

The chart below is the S&P 500 High Dividend Low Volatility ETF versus the S&P 500 Index. During the recent decline, dividend stocks were neither “safe,” nor “low volatility.”

But what about previous “bear markets?” Since most ETF’s didn’t exist before 2000, we can look at the “strategy” with a mutual fund like Fidelity’s Dividend Growth Fund (FDGFX)

As you can see, there is little relative “safety” during a market reversion. The pain of a 38%, 56%, or 30%, loss, can be devastating particularly when the prevailing market sentiment is one of a “can’t lose” environment. Furthermore, when it comes to dividend-yielding stocks, the psychology is no different; a 3-5% yield, and a 30-50% loss of capital, are two VERY different issues.

A Better Way To “Invest For The Dividend”

“Buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for a discussion of chart)

So, what’s the better way to invest for dividends? Let’s go back to our example of Exxon Mobil for a moment. (This is for illustrative purposes only and not a recommendation.)

In 2018, Exxon Mobil broke below its 12-month moving average as the overall market begins to deteriorate.

If you had elected to sell on the break of the moving average, your exit price would have been roughly \$70/share. (For argument sake, you stayed out of the position even though XOM traded above and below the average over the next few months.)

Let’s rerun our math from above.

• In 2018, an individual bought 100 shares at \$80.
• In 2019, the individual sold 100 shares at \$70.

Investment Return (-\$1000.00 ) + Dividends of \$323 (Yr 1) and \$343 (Yr 2)  = Net Loss of \$334

Given the original \$8,000 investment has only declined to \$7,666, the individual could now buy 200 shares of Exxon Mobil with a dividend of \$3.48 and a 9.3% annual yield.

Let’s compare the two strategies.

• Buy And Hold: 100 shares bought at \$80 with a current yield of 4.35%
• Risk Managed: 200 shares bought at \$40 with a current yield of 9.3%

Which yield would you rather have in your portfolio?

In the end, we are just human. Despite the best of our intentions, emotional biases inevitably lead to poor investment decision-making. This is why all great investors have strict investment disciplines they follow to reduce the impact of emotions.

I am all for “dividend investment strategies,” in fact, dividends are a primary factor in our equity selection process. However, we also run a risk-managed strategy to ensure we have capital available to buy strong companies when the opportunity presents itself.

The majority of the time, when you hear someone say “I bought it for the dividend,” they are trying to rationalize an investment mistake. However, it is in the rationalization that the “mistake” is compounded over time. One of the most important rules of successful investors is to “cut losers short and let winners run.”

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

Quick Take: The Risk Of Algos

Mike ‘Wags’ Wagner: ‘You studied the Flash Crash of 2010 and you know that Quant is another word for wild f***ing guess with math.’

Taylor Mason: ‘Quant is another word for systemized ordered thinking represented in an algorithmic approach to trading.’

Mike ‘Wags’ Wagner: ‘Just remember never won a World Series .’ – Billions, A Generation Too Late

My friend Doug Kass made a great point on Wednesday this week:

“General trading activity is now dominated by passive strategies (ETFs) and quant strategies and products (risk parity, volatility trending, etc.).

Active managers (especially of a hedge fund kind) are going the way of dodo birds – they are an endangered species. Failing hedge funds like Bill Ackman’s Pershing Square is becoming more the rule than the exception – and in a lower return market backdrop (accompanied by lower interest rates), the trend from active to passive managers will likely continue and may even accelerate this year.”

He’s right, and there is a huge risk to individual investors embedded in that statement. As JPMorgan noted previously:

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets.

While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.

As long as the algorithms are all trading in a positive direction, there is little to worry about. But the risk happens when something breaks. With derivatives, quantitative fund flows, central bank policy and political developments all contributing to low market volatility, the reversal of any of those dynamics will be problematic.

There are two other problems currently being dismissed to support the “bullish bias.”

The first, is that while investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.

Yes, margin debt does increase as asset prices rise. However, just as the “leverage” provides the liquidity to push asset prices higher, the reverse is also true.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. As I noted previously:

“The head of the BOE Mark Carney himself has warned about the risk of ‘disorderly unwinding of portfolios’ due to the lack of market liquidity.

‘Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

When the “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Algo’s were not a predominant part of the market prior to 2008 and, so far, they have behaved themselves by continually “buying the dips.” That support has kept investors complacent and has built the inherent belief “this time is different.”

But therein lies the “risk of the robots.”

What happens when these algo’s reverse course and begin to “sell the rallies” in unison?

I don’t want to be around to find out.

You Were Warned: MLP’s & “I Bought It For The Dividend”

In early 2016, I warned investors about the dangers of Master Limited Partnerships (MLP’s) and chasing dividend yields. To wit:

One of the big issues starting in 2016 will be the reversions of MLP’s. Many investors jumped into MLP’s believing them to be a ‘no-brainer’ investment for income with little or no price risk. As I have suggested many times over the last few years, this was ALWAYS a false premise. In 2016, many companies that spun-off pipelines in the form of MLP’s, will ‘revert’ them back into the parent company as they can buy the asset back very cheaply, boosting cash flows of the parent company, during a period of weak commodity prices. This will leave MLP investors who just ‘bought it for the dividend,’ receiving back much less than they invested to begin with.”

That prediction continues to come to fruition with the latest announcement by Tallgrass Energy Partners. Via Bloomberg:

“Tallgrass Energy GP, LP announced late on Monday it would buy out the public unit-holders owning about two-thirds of its master limited partnership, Tallgrass Energy Partners, LP. It’s the latest MLP to be shuffled off and a good example of why the ranks are thinning in this once-beloved corner of the market.

Tallgrass Energy Partners listed in 2013, when the combination of yield and growth — predicated on the resurgence in U.S. oil and gas production — offered by MLPs had them in high demand. The general partner, Tallgrass Energy GP, listed two years later, when oil’s bear market had started but MLPs hadn’t yet fallen out of favor. That followed soon after.”

The “yield” is the problem.

“Tallgrass actually avoided cutting its quarterly distributions in the downturn, making it a relatively rare beast and explaining much its outperformance. But those high distributions evidently didn’t inspire enough confidence — and just became a high cost of capital instead.”

But it isn’t just Tallgrass, but most MLP’s. The “yields” reflected by MLP’s are actually understatements of the true cost of equity. Once prices fall, both on the MLP and with the underlying commodity, the entire premise of “raising capital cheaply” gets called into question. It then becomes much more opportunistic to “revert” the MLP back into the parent company.

This is the point where a common“investment thesis” falls apart.

The Dangers Of “I Bought It For The Dividend”

“I don’t care about the price, I bought it for the yield.”

First of all, let’s clear up something.

Tallgrass Energy Partners pays out an annual dividend of \$3.86 and is currently priced at \$39.24 (as of this writing) which translates into a yield of 9..84%. (3.86/39.24)

Let’s assume an individual bought 100 shares at \$50 in 2017 which would generate a “yield” of 7.72%.

Investment Return (39.24 – 50 = -10.76) + Dividend of \$3.86  = Net Loss of \$6.90

“The terms — laid out in a perfunctory seven-slide deck — are as austere as you might expect in a deal where the limited partners don’t get to vote. The parent offered a nominal premium of about 1 percent to Tallgrass Energy Partners’ minority unitholders. The exchange ratio of two shares for each unit was essentially in line with the average since the general partner listed.”

That’s not a great deal, but better than a “sharp stick in the eye.”

Here is the important point. You do NOT receive a “yield.”

“Yield” is just a mathematical calculation.

The “yield” can, and often does, go away.

I previously posted an article discussing the “Fatal Flaws In Your Financial Plan” which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

“‘The single biggest mistake made in financial planning is NOT to include variable rates of return in your planning process.’

This statement puzzles me. If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to increase. It is true that the total value of the portfolio will fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends are a wonderful thing, Lance. Dividends usually go up even when the stock market goes down.

This comment drives to the heart of the “buy and hold” mentality and, along with it, many of the most common investing misconceptions.

Let’s start with the notion that “dividends always increase.”

When a recession/market reversion occurs the “cash dividends” don’t increase but the “yield” does as prices collapse. Well, that is until the cash dividend is cut or is eliminated entirely.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks, however, leading up to the financial crisis there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred dot.com bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

Of course, not EVERY company cut dividends by 12%. Some didn’t. But many did, and some even eliminated their dividends entirely, to protect cash flows and creditors.

Due to the Federal Reserve’s suppression of interest rates since 2009, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief “there is no alternative.” The resulting “dividend chase” has pushed valuations dividend yielding companies to excessive levels disregarding underlying fundamental weakness.

As with the “Nifty Fifty” heading into the 1970’s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices and the actual dividends being paid out throughout history.

While I completely agree that investors should own companies that pay dividends (as it is a significant portion of long-term total returns)it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress.

In fact, it is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently, the economy may not be as “strong as an ox” currently:

March 2018 saw the second-largest ever number of dividend cuts be declared by U.S. firms and funds in a single month. The month’s 92 dividend cuts reported was just one shy of the record 93 cuts that were recorded during the ‘Great Dividend Raid of 2012.””

Here are the dividend numbers as we know them for March 2018 today:

• There were 4,392 U.S. firms that issued some kind of declaration regarding their dividends in March 2018, which is up significantly from February 2018’s 3,493 and the year-ago March 2017’s 4,041. This figure is also the third highest number on record, coming behind December 2017’s 4,506 and December 2015’s 4,422.
• In March 2018, there were 36 U.S. firms that announced that they would pay an extra, or special, dividend. That figure is slightly down from the 38 firms that made similar declarations in both February 2018 and back in March 2017.
• 167 U.S. companies declared that they would increase their dividends in March 2018, which is down from 322 in February 2018, but up significantly from the 141 that boosted their dividends in March 2017. For the first quarter of 2018, a total of 807 dividend rises were recorded, which ranks third for any quarter’s total of dividend increases, behind March 2014’s 819 and March 2015’s 812.
• The 92 dividend cuts reported for March 2018 is up substantially from the 20 that were recorded in February 2018 and also from the 76 recorded back in March 2017, when the distress in the U.S. oil and gas industry was bottoming.
• 9 U.S. firms omitted paying dividends in March 2018, the same as in February 2018, but which is up from the 2 firms that did a year earlier in March 2017.”

During the next major market reversion, as prices collapse, so will the dividend payouts.

This is when the “I bought it for the dividend plan” doesn’t work out.

Why?

Because EVERY investor has a point, when prices fall far enough, that regardless of the dividend being paid they WILL capitulate and sell the position. This point generally comes when dividends have been cut and capital destruction has been maximized.

Psychology

Of course, while individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do.

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making.

Ultimately, when markets decline, there is a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, so does the related anxiety until individuals seek to “avert further loss” by selling. It is generally believed that dividend yielding stocks offer protection during bear market declines. The chart below is the Fidelity Dividend Growth Fund (most ETF’s didn’t exist prior to 2000), as an example, suggests this is not the case.

As you can see, there is little relative “safety” during a major market reversion. The pain of a 38% loss, or a 56% loss, is devastating particularly when the prevailing market sentiment is one of a “can’t lose” environment. Furthermore, when it comes to dividend yielding stocks, the psychology is no different – a 3-5% yield and a 30-50% loss of capital are two VERY different issues.

Buy & Hold Won’t Get You There Anyway

Most importantly, as it relates to this discussion, is the “fact” that “buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for discussion of chart)

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

While many studies show that “buy and hold,” and “dividend” strategies do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits. Furthermore, with valuations and market correlations at extremely elevated levels, the next major market correction will be equally unkind to all investors.

In the end, those who utter the words “I bought it for the dividend” are simply trying to rationalize an investment mistake. However, it is in the rationalization the “mistake” is compounded over time. One of the most important rules of successful investors is to “cut losers short and let winners run.”

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

Tallgrass won’t be the last MLP, or corporation, to cut dividends. When the next major mean-reverting begins, you can “lie” to yourself for a while that you are fine with just the dividend. Eventually, when you have lost enough capital, and the dividend is cut or eliminated, you will eventually sell.

It happens every time.

But, you have been warned…again.

This Cycle Will End – The Simple Math Of Forward Returns

In this past weekend’s newsletter, I discussed the potential for an end to the current bull market cycle. It was not surprising that even before the “digital ink was dry,” I received emails and comments questioning the premise.

It is certainly not surprising that after one of the longest cyclical bull markets in history that individuals are ebullient about the long-term prospects of investing. The ongoing interventions by global Central Banks have led to T.T.I.D. (This Time Is Different) and  T.I.N.A. (There Is No Alternative) which has become a pervasive, and “Pavlovian,” investor mindset. But therein lies the real story.

The chart below shows every economic expansion going back to 1871 and the subsequent market decline.

This chart should make one point very clear – this cycle will end.

However, for now, there is little doubt the bullish bias exists as individuals continue to hold historically high levels of equity and leverage, chasing yield in the riskiest of areas, and maintaining relatively low levels of cash as shown in the charts below.

There are only a few people, besides me, that discuss the probabilities of lower returns over the next decade. But let’s do some basic math.

First, the general consensus is that stocks will return:

• 6%-8%/year in real (inflation-adjusted) terms,
• plus or minus whatever changes we see in valuation ratios.

Plug in the math and we get the following scenarios:

1. If P/E10 declines from 30X to 19X  over the next decade, equity returns should be roughly 3%/year real or 5%/year nominal.
2. If P/E10 declines to 15X, returns fall to 1%/year real or 3%/year nominal.
3. If P/E10 remains at current levels, returns should be 6%/year real or 8%/year nominal.

Here is the problem with the math.

First, this assumes that stocks will compound at some rate, every year, going forward. This is a common mistake that is made in return analysis. Equities do not compound at a stagnant rate of growth but rather experience a rather high degree of volatility over time.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.

Here is another way to view the difference between what was “promised,” versus what “actually” happened. The chart below takes the average rate of return, and price volatility, of the markets from the 1960’s to present and extrapolates those returns into the future.

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over the long-term.

The second point, and probably most important, is that YOU DIED long before you realized the long-term average rate of return.

The chart below shows the S&P 500 as compared to annualized returns and the average of market returns since 1900.  Over the last 118 years, the market has NEVER produced a 6% every single year even though the average has been 6.87%.

However, assuming that markets have a set return each year, as you could expect from a bond, is grossly flawed. While there are many years that far exceeded the average of 6%, there are also many that haven’t. But then again, this is why 6% is the “average” and NOT the “rule.”

Secondly, and more importantly, the math on forward return expectations, given current valuation levels, does not hold up.  The assumption that valuations can fall without the price of the markets being negatively impacted is also grossly flawed. History suggests, as shown in the next chart, that valuations do not fall without investment returns being negatively impacted to a large degree.

So, back to the “math” to prove this is true.

If we assume that despite the weak economic growth at present, the Federal Reserve is successful at getting nominal GDP back up to a historical growth rate of 6.3% annually. While this is not realistic if you look at the data, when markets are near historical peaks, assumptions tend to run a bit wild. Unfortunately, such assumptions have tended to have rather nasty outcomes. But I digress.

If we use a market cap / GDP ratio of 1.25 and an S&P 500 dividend yield of just 2%, what might we estimate for total returns over the coming decade using John Hussman’s formula?

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually.

We can confirm that math by simply measuring the forward TOTAL return of stocks over the next 10-years from each annual valuation level.

Forward 20-year returns do not get a whole lot better.

But even if you are optimistic, and you do manage to eek out forward returns of 5-6% over the next 20-years, you will never reach your financial goals due to the inherent destruction of capital along the way. (See “You Should Never Time The Market?”)

John Hussman once penned:

Extraordinary long-term market returns come from somewhere. They originate in conditions of undervaluation, as in 1950 and 1982. Dismal long-term returns also come from somewhere – they originate in conditions of severe overvaluation. Today, as in 2000, and as in 2007, we are at a point where ‘this’ is like this. So ‘that’ can be expected to be like that.”

Nominal GDP growth is likely to be far weaker over the next decade. This will be due to the structural change in employment, rising productivity which suppresses real wage growth, still overly leveraged household balance sheets which reduce consumptive capabilities and the current demographic trends.

Most mainstream analysis makes sweeping assumptions that are unlikely to play out in the future. The market is extremely volatile which exacerbates the behavioral impact on forward returns to investors and the most recent Dalbar Study of investor behavior shows this to be the case. Over the last 30-years, the S&P 500 has had an average return of 10.16% while equity fund investors had a return of just 3.98%.

So much for the 6% return assumptions in financial plans.

This has much to do with the simple fact that investors chase returns, buy high, sell low and chase ethereal benchmarks. (Read “Why You Shouldn’t Benchmark Your Portfolio”) The reason that individuals are plagued by these emotional behaviors is due to well-meaning articles espousing stock ownership at cyclical valuation peaks.

Sure, it is entirely possible the current cyclical bull market is not over…yet.

Momentum driven markets are hard to kill in the latter stages particularly as exuberance builds. However, they do eventually end. That is unless the Fed has truly figured out a way to repeal economic and business cycles altogether. As we enter into the ninth year of economic expansion we are likely closer to the next contraction than not. This is particularly the case as the Federal Reserve continues to build a bigger economic void in the future by pulling forward consumption through its monetary policies.

Will the market likely be higher a decade from now? A case can certainly be made in that regard. However, if interest rates or inflation rise sharply, the economy moves through a normal recessionary cycle, or if Jack Bogle is right – then things could be much more disappointing. As Seth Klarman from Baupost Capital once stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same mainstream analysis at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same.

“History repeats itself all the time on Wall Street”  – Edwin Lefevre

Recession: When You See It, It Will Be Too Late

“There are no signs of recession. Employment growth is strong. Jobless claims are low and the stock market is up.”

This is heard almost daily from the media mainstream pablum.

The problem with a majority of the “analysis” done today is that it is primarily short-sighted and lazy, produced more for driving views and selling advertising rather than actually helping investors.

For example:

“The economy is currently growing at more than 2% annualized with current estimates near 2% as well.”

If you are growing at 2%, how could you have a recession anytime soon?

Let’s take a look at the data below of real economic growth rates:

• January 1980:        1.43%
• July 1981:                 4.39%
• July 1990:                1.73%
• March 2001:           2.30%
• December 2007:    1.87%

If you look at each of those dates, the economy was clearly growing. But each of those dates is the growth rate of the economy immediately prior to the onset of a recession.

You will remember that during the entirety of 2007, the majority of the media, analyst, and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”

I myself was rather brutally chastised in December of 2007 when I wrote that:

“We are now either in, or about to be in, the worst recession since the ‘Great Depression.’”

Of course, a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis (BEA), the recession was officially revealed. Unfortunately, by then it was far too late to matter.

It is here the mainstream media should have learned their lesson. But unfortunately, they didn’t.

The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.

There are three lessons that should be learned from this:

1. The economic “number” reported today will not be the same when it is revised in the future.
2. The trend and deviation of the data are far more important than the number itself.
3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

For example, the level of jobless claims is one data series currently being touted as a clear example of why there is “no recession” in sight. As shown below, there is little argument that the data currently appears extremely “bullish” for the economy.

However, if we step back to a longer picture we find that such levels of jobless claims have historically noted the peak of economic growth and warned of a pending recession.

This makes complete sense as “jobless claims” fall to low levels when companies “hoard existing labor” to meet current levels of demand. In other words, companies reach a point of efficiency where they are no longer terminating individuals to align production to aggregate demand. Therefore, jobless claims naturally fall.

But there is more to this story.

Less Than Meets The Eye

The Trump Administration has taken a LOT of credit for the recent bumps in economic growth. We have warned this was not only dangerous, credibility-wise, but also an anomaly due to three massive hurricanes and two major wildfires that had the “broken window” fallacy working overtime.

“The fallacy of the ‘broken window’ narrative is that economic activity is only changed and not increased. The dollars used to pay for the window can no longer be used for their original intended purpose.”

If economic destruction led to long-term economic prosperity, then the U.S. should just regularly drop a “nuke” on a major city and then rebuild it. When you think about it in those terms, you realize just how silly the whole notion is.

However, in the short-term, natural disasters do “pull forward” consumption as individuals need to rebuild and replace what was previously lost. This activity does lead to a short-term boost in the economic data, but fades just as quickly.

A quick look at core retail sales over the last few months, following the hurricanes, shows the temporary bump now fading.

The other interesting aspect of this is the rise in consumer credit as a percent of disposable personal income. The chart below indexes both consumer credit to DPI and retail sales to 100 starting in 1993. What is interesting to note is the rising level of credit card debt required to sustain retail sales.

Given that retail sales make up roughly 40% of personal consumption expenditures which in turn comprises roughly 70% of GDP, the impact to sustained economic growth is important to consider.

Furthermore, what the headlines miss is the growth in the population. The chart below shows retails sales divided by the current 16-and-over population. (If you are alive, you consume.)

Retail sales per capita were previously on a 5% annualized growth trend beginning in 1992. However, after the financial crisis, the gap below that long-term trend has yet to be filled as there is a 23.2% deficit from the long-term trend. It is also worth noting the sharp drop in retail sales per capita over just the last couple of months in particular.

Since 1992, as shown below, there have only been 5-other times in which retail sales were negative 3-months in a row (which just occurred). Each time, the subsequent impact on the economy, and the stock market, was not good.

So, despite record low jobless claims, retail sales remain exceptionally weak. There are two reasons for this which are continually overlooked, or worse simply ignored, by the mainstream media and economists.

The first is that despite the “longest run of employment growth in U.S. history,” those who are finding jobs continues to grow at a substantially slower pace than the growth rate of the population.

If you don’t have a job, and are primarily living on government support (1-of-4 Americans receive some form of benefit) it is difficult to consume at higher levels to support economic growth.

Secondly, while tax cuts may provide a temporary boost to after-tax incomes, that income boost is simply being absorbed by higher energy, gasoline, health care and borrowing costs. This is why 80% of Americans continue to live paycheck-to-paycheck and have little saved in the bank. It is also why, as wages have continued to stagnate, the cost of living now exceeds what incomes and debt increases can sustain.

As I have discussed several times during the 4th-quarter of 2017:

Very likely, the next two quarters will be weaker than expected as the boost from hurricanes fade and higher interest rates take their toll on consumers. So, when mainstream media acts astonished that economic growth has once again slowed, you will already know why.”

Not surprisingly the economic data rolling in has been exceptionally weak and the first quarter GDP growth is now targeted at less than 2% annualized growth.

However, it is not only in the U.S. the economic “bump” is fading, but globally as well as Central Banks have started to remove their monetary accommodations. As noted by the ECRI:

“Our prediction last year of a global growth downturn was based on our 20-Country Long Leading Index, which, in 2016, foresaw the synchronized global growth upturn that the consensus only started to recognize around the spring of 2017.

With the synchronized global growth upturn in the rearview mirror, the downturn is no longer a forecast, but is now a fact.

The chart below shows that quarter-over-quarter annualized gross domestic product growth rates in the three largest advanced economies — the U.S., the euro zone, and Japan — have turned down. In all three, GDP growth peaked in the second or third quarter of 2017, and fell in the fourth quarter. This is what the start of a synchronized global growth downswing looks like.”

“Still, the groupthink on the synchronized global growth upturn is so pervasive that nobody seemed to notice that South Korea’s GDP contracted in the fourth quarter of 2017, partly due to the biggest drop in its exports in 33 years. And that news came as the country was in the spotlight as host of the winter Olympics.

Because it’s so export-dependent, South Korea is often a canary in the coal mine of global growth. So, when the Asian nation experiences slower growth — let alone negative growth — it’s a yellow flag for the global economy.

The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

You can see the slowdown occurring “real time” by taking a look at Personal Consumption Expenditures (PCE) which comprises roughly 70% of U.S. economic growth. (It is also worth noting that PCE  growth rates have been declining since 2016 which belies the “economic growth recovery” story.)

The point here is this:

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.”

While there may currently be “no sign of recession,” there are plenty of signs of “economic stress” such as:

The shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment which has skewed the seasonal-adjustments in economic data. This makes every report from employment, retail sales, and manufacturing appear more robust than they would be otherwise. This is a problem mainstream analysis continues to overlook but will be used as an excuse when it reverses.

While the calls of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000 or 2007 either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

As Howard Marks once quipped:

“Being right, but early in the call, is the same as being wrong.”

While being optimistic about the economy and the markets currently is far more entertaining than doom and gloom, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

Is there a recession currently? No.

Will there be a recession in the not so distant future? Absolutely.

But if you wait to “see it,” it will be too late to do anything about it.

Whether it is a mild, or “massive,” recession will make little difference to individuals as the net destruction of personal wealth will be just as damaging. Such is the nature of recessions on the financial markets.

Is The Dot.Com Bubble Back?

Let me start out by saying I hate market comparisons.

While history certainly does “rhyme,” they are never the same. This is especially the case when it comes to the financial markets. Chart patterns may align from time to time, but such is more a function of pattern-fitting than anything else.

However, when it comes to fundamentals, standard-deviations, extensions, etc., it is a different story. A recent article by Ryan Vlastelica brought this to mind.

“While the strategy of investing in internet-related companies will likely always be first associated with the dot-com era, the long-lived bull market has proved to be just as strong a period for a sector that has influenced nearly every aspect of the economy.

Friday marks the ninth anniversary of the financial crisis bottom, and since that period—by one measure, the start of the current bull market—internet stocks have been among the best performers on Wall Street.”

“’The current tech rally is possibly the greatest investment story ever told,’ wrote Vincent Deluard, global macro strategist at INTL FCStone, who was speaking about the sector broadly, and not these ETFs in particular. He noted that the MSCI World Technology Index has added \$5.7 trillion in market capitalization since February 2009, ‘when the entire sector amounted to just \$1.5 trillion.’”

Since Ryan was probably in elementary school during the “Dot.com” era, and many current fund managers weren’t managing money either, it is easy to dismiss “history” under a “this time is different” scenario. Even the ETF’s used as an example of the “this time is different” scenario didn’t even exist prior to the “dot.com  bubble” (The QQQ didn’t come into existence until 1999)

Unfortunately, while the names of the companies may have changed, the current “dot.com boom” is likely more than just a “rhyme” with the past.

Investors Once Again Being Misled

From a fundamental basis, there is a difference between today and the “Dot.com days of yore.” In 1999, “dot.com” companies were all bunched together and few actually made money. Fast forward to 2018, and the division between an “internet company” and every other company is now invisible. In fact, companies like Apple and Amazon are no longer even classified as “technology” companies but rather consumer goods companies.

But nonetheless, fundamentals don’t discriminate between classifications, and once again investors are paying excessively high prices for companies that generate very little, if any, profit.

Just after the “dot.com” bust, I wrote a valuation article quoting Scott McNeely, who was the CEO of Sun Microsystems at the time. At its peak, the company was trading at 10x its sales. (Price-to-Sales ratio) In a Bloomberg interview Scott made the following point.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees.That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at \$64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

How many of the following “dot.com” companies do you currently own which are currently carrying price-to-sales in excess of 10x?  (Price-to-Sales above 2x becomes expensive. If I included companies with P/S of 5x or more, the list was just too expansive for this post.)

As noted above, there were only 3-ETF’s that existed just prior to the “dot.com” bubble -SPY, QQQ, and DIA. In order to do some better comparative analysis, I had to dig to find a technology-based mutual fund that existed back in 1990. Not surprisingly, there were very few but the T. Rowe Price Science and Technology (PRSCX) fund fit the bill and tracks the technology index very closely.

When we compare the fund to Shiller’s CAPE ratio, not surprisingly, since Technology makes up a quarter of the S&P 500 index, there is a high correlation between Technology and overall market valuation expansion and contraction.

As was the case in 1998-2000, the fund exploded higher as exuberance over the transformation of the world was occurring before our eyes. Investors globally were willing to pay “any price” to “get in on the action.”  Currently, investors are once again chasing returns in the “FANG” stocks with little regard to underlying value. The near vertical ramp in the fund is reminiscent of the late 1990’s as valuations continue to escalate higher.

The chart below shows this a bit more clearly. It compares the fund to both the RSI (relative strength index) and inflation-adjusted reported earnings of the S&P 500 on a QUARTERLY basis. Using quarterly data smooths volatility of these measures over time.

A couple of interesting points arise.

1. The RSI of the market is as overbought today as it was leading up to the “Dot.com” crash and more overbought today than just before the “financial crisis.”
2. Despite massive stock buybacks and cost reductions through wage and employment suppression, reported earnings have only grown by a little more than \$11 / share since the peak of the market in 2007. In other words, despite the ongoing bullish commentary about how great earnings are, they have actually only achieved a 1.14% annualized rate of growth.

Of course, investors have disregarded the lack of real earnings growth. The valuation surge is also shown in the analysis below. I have taken the price of the fund and divided by the inflation-adjusted reported earnings of the S&P 500, or a modified “P/E” ratio. While not a strictly apples-to-apples comparison, the point is that since Technology makes up roughly 25% of the market, it is a big driver of the “P” and not a huge contributor to the “E.”

Again, on this basis, investors are once again paying a high price for poor fundamental quality in the “hope” that someday the fundamentals will catch up with the price. It has never been the case, but one can always “hope.”

Is The Dot.Com Bubble Back?

Whether you believe there is a “bubble” in the Technology stocks, or the markets, is really not important. There are plenty of arguments for both sides.

At the peak of every bull market in history, there was no one claiming that a crash was imminent. It was always the contrary with market pundits waging war against those nagging naysayers of the bullish mantra that “stocks have reached a permanently high plateau” or “this is a new secular bull market.”  (Here is why it isn’t.)

Yet, in the end, it was something unexpected, unknown or simply dismissed that devastated investors.

This is why the discussion of “this time is not like the last time” is largely irrelevant.

Individuals no longer “invest” to become a “shareholder” in a publicly traded business. The “quaint concept” of “valuations” died with the mainstreaming of investing during the 1990’s as the “Wall Street Casino” opened for business.

Today, investors only think in terms of speculating on “electronically traded bits of paper” in the hopes the value will rise over time. The problem, of course, is they are never told when to “sell” to capture that valuation increase which is the most critical aspect of the investment process. Instead, individuals continue to “bet” the “greater fool” will always appear.

For now, the “bullish case” remains alive and well. The media will go on berating those heretics who dare to point out the risks that prevail, but the one simple truth is “this time is indeed different.”

“When the crash ultimately comes the reasons will be different than they were in the past – only the outcome will remain same.”

Eventually, like all amateur gamblers in the Las Vegas casinos, the ride is a “blast while it lasts” but in the end, the “house always wins.”