Ralph Waldo Emerson wrote:

“A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. With consistency a great soul has simply nothing to do. He may as well concern himself with his shadow on the wall. Speak what you think now in hard words, and to-morrow speak what to-morrow thinks in hard words again, though it contradict everything you said to-day. — 'Ah, so you shall be sure to be misunderstood.' — Is it so bad, then, to be misunderstood? Pythagoras was misunderstood, and Socrates, and Jesus, and Luther, and Copernicus, and Galileo, and Newton, and every pure and wise spirit that ever took flesh. To be great is to be misunderstood.”

Although many definitions have been offered for Mr. Emerson’s now-famous tome, I have interpreted it to mean: Think outside the box. Do not become chained to conformity and historical repetition. Use your own senses to determine what is happening and act/react accordingly. After all, the aforementioned passage is from Mr. Emerson’s essay “Self-Reliance.” The message of “Self-Reliance” was; there is a “need for each individual to avoid conformity and false consistency.”

For me, these are words to live by. For many professionals in the financial industry, consistency of thought or strategy, foolish or not, is a mainstay of their business lives. The group think on Wall Street is to stick with what works until it doesn’t then stick with it a while longer. As such, low U.S. Treasury yields and high earnings multiples among dividend paying stocks, such as utilities, are automatically viewed as fear trades. This completely ignores other factors involved in current asset allocations.

As I have stated many times in recent months, there is enormous demographic demand for interest-paying and dividend-paying investments. The greatest (non-central bank) demand comes from institutions such as insurance companies and pension funds. It is unlikely that these institutions are buying bonds and dividend stocks out of fear. It is far more likely that they are buying income paying instruments to generate income to meet actuarial needs. The last thing pension funds want (many of which are not particularly well-funded to begin with) is to burn principal. This is particularly true when one considers that life expectancy continues to increase. Still, the hobgoblins continue to wreak havoc on the minds of Wall Street strategists and pundits.

A popular metric which Wall Street analysts and strategists use to measure the attractiveness of stocks is the price earnings ratio (P/E). With the utility sector trading with a P/E of just over 20, the hobgoblins consistently whisper in the ears of many markets strategists: “That P/E is just too high, rotate into consumer cyclical and growth stocks before others do.” In my opinion, this is an example of foolish consistency.

Based on the demographic needs of investors, individual as well as institutional, it appears as though the capital which has been invested in utility stocks probably came from the fixed income market and not the equity markets. I firmly believe that, if long interest rates surged higher, much capital that currently resides in dividend-paying stocks would move back into bonds. Thus, dividend yields versus U.S. Treasury benchmarks and comparisons with corporate bond yields are probably better valuation metrics for dividend-paying stocks, particularly those with little growth potential (such as utilities) than P/E ratios. This is like measuring the value of an SUV by comparing it to a sports car. A much more useful comparison would be versus a mini-van, a vehicle which serves a similar purpose.

This is not to say that prices of dividend stocks will not get battered if long-term interest rates rise. They probably will. However, given the needs of investors who have poured money into dividend stocks, bonds are probably the natural alternative.

If this is so clear, why do so many strategists, analysts and financial journalists miss this connection? This goes back to foolish consistency. They tend to look at markets of the past and assume that everything repeats. Bonds and utility stocks were purchased in times of fear in the past. Thus, buying of bonds and utility stocks must indicate fear again. This also smacks of the post hoc, ergo propter hoc fallacy.

One phenomenon that has bedeviled market watchers is that retail investors have not re-entered the equity markets in a big way, since the financial crisis. The prevailing theory among market watchers is that investors are scared. Eventually, these investors will re-enter the equity markets, much as they did ten and twenty years ago. The problem with this theory is that these investors, who were in their 40s twenty years ago and 50s ten years ago are now in their 60s and are much less interested in (or in need of) growth investments. For many baby boomers (who drove growth investing for the previous 30 years), traditional 60/40 stock/bond strategy is as dead as the venerable Mr. Emerson. The trend over the next two decades could be a 50/50 or 40/60 equity/bond allocation, with a greater emphasis on dividend-paying stocks. However, those darn hobgoblins keep clouding the minds of market strategists and analysts.

Now this is not to say that there is no fear in the markets. The rally in gold is a sign of fear. I believe the fear is misplaced, but it is a sign of fear, nonetheless. Why do I believe that fear is misplaced, as represented by the gold market? Because gold trades in dollars and a weakening U.S. dollar does not appear a valid base case scenario. Although the USD may not strengthen much from here and could, from time to time, weaken, a plunging USD scenario seems a bit far-fetched at the present time.

For inflation to begin ripping higher, the U.S. would need to see robust inflation pressures. The latest readings of inflation indicate that it has stabilized, even ticking down a bit, by some measures. What about the potential for current levels of mega-accommodative monetary policy conditions producing inflation pressures? Now we go back to hobgoblins and foolish consistency. In the past, current monetary policy would have been extremely accommodative. Based on economic conditions, it appears that current levels of U.S. monetary accommodation might be near neutral. Even the Fed, which has been reluctant to alter its view of what is normal, is singing a different tune. I believe the gold rally is based on false assumptions, but it is what it is.

Meanwhile, the bond market is pricing in a low-rate normal several years out. Really, the bond market has priced in a low rate normal as far as fixed income futures go out. Once again, investment strategists, market analysts and financial journalists declare the bond market is wrong. Even if one has some doubts about the bond market’s message, one must concede that it has been mostly correct during the past four years and that the aforementioned professionals have been mainly incorrect. When does the bond market gain some credibility? When do the aforementioned professionals begin to lose credibility?

In my opinion, the (thus far) incorrect professionals remain credible because investment professionals and investors like their message. We need to separate what we would like to happen from what will possibly, or even probably, happen. In our own individual lives we can create our own reality. This is not possible in the capital markets. The markets will always provide a rude slap in the face to bring investors and market participants back to reality, whatever that may be.

We cannot ignore global interest rate conditions. Take a look at global sovereign debt yields:

Major Global Developed Yield Curves (Bloomberg):

German and Japanese sovereign debt yields are negative until the 20-year mark. Swiss sovereign debt yields are negative all the way out to its longest maturity, 50 years. German and Japanese negative yields are negative far out the curve because inflation is low and central banks are attempting to boost their economies by making borrowing attractive and weakening their currencies by buying bonds. The Swiss are doing the same to discourage capital flight into the Swiss franc, which would strengthen the currency and weigh heavily the Swiss economy.

With demographics auguring for slower structural growth and little willingness among elected officials, or the electorate for that matter, to implement pro-growth fiscal and regulatory policies (which would reduce business restrictions, lower corporate taxes and reduce labor protections), central banks are forced to ad layer after layer of monetary policy accommodation just to maintain the current status quo. Ergo, a new structural normal.

The wealth management industry has done an impressive job convincing investors and advisors that a return to some semblance of the old normal is nigh and that monetary policy (in the right amount) will get the economy there. Is this another case of foolish consistency? It sure seems like it. I believe that foolish consistency was to blame for the recession fears which pervaded the markets at the beginning of the year. Market participants, strategists and analysts remained married to their old models and assumed that correlations established in the past were durable. They were not. We all know what happens when we assume. Well, it happened during the first two months of 2016 and it appears to be happening now.

In a paper published June 30^th St. Louis Fed president, James Bullard, states:

“The St. Louis Fed had been using an older narrative since the financial crisis ended. That narrative has now likely outlived its usefulness, and so it is being replaced by a new narrative. The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. In this new narrative, the concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.”

Simply stated: Models which assumed a reversion to the previous 30-year mean are useless. Structural conditions have changed and, since we don’t know what the new normal might bring, it is impossible to provide reliable economic forecasts, nor is it possible to be confident that any policy action will provide the desired outcome. Folks, auto pilot is off. Grab the controls.

This is what I have been suggesting for several years. Events since then have only reinforced my opinion that traditional economic, monetary policy and market models are useless and should be relegated, if not to the trash heap of finance, at least to a drawer someplace for use at a much later date. (2) (5) (6)