Nick's January Passive Income Update

I discuss recent market volatility and why my passive income stream serves as an anchor for me throughout this storm.

Needless to say, these last 5 or 6 trading days have been interesting. Some might call them guy wrenching, others might consider them exciting, and some might even be ecstatic, depending on their market positioning. As a long-only portfolio manager with ~93% of my portfolio exposed to equities, the market’s recent sell-off has been painful to me (on paper, anyway). I’ve surely taken my lumps, though I had to admit that fear hasn’t crept very far into the equation for me because I can’t help but imagine that this correction will end up being nothing more than that: a correction.

And, in the meantime, although I'm seeing the value of my net work fall, I'm pleased to see my dividend income stream post tremendous gains. This just goes to show that a DGI investment strategy can work wonders in a variety of market environments.

I might even argue that this sell-off is healthy for the markets. Complacency and exuberance worry me as a long-term investor. When there is no fear in the markets valuations oftentimes get pushed up to unsustainable levels. It’s euphoria like this that lead to major market crashes. I’m sure that investors, especially younger ones who’ve never experienced much volatility, more or less a significant bear market, might feel like the ~10% drop we’ve experienced in the major market averages since late January is a crash.

Looking at the data, it’s far from that. Sure, the 1,600 point drop that the DOW experienced last Friday wasn’t fun to see. However, it’s important to realize that these big red quadruple digit numbers don’t represent as much pain as it seems due to the market previously sitting at all-time highs. We’re getting anxious about down days in the 2-4% range; just imagine what investors must have felt like in 1987 when the markets sunk more than 20% in a single trading session.

Believe me, I don’t like looking at my portfolio statement at the end of the day and seeing that I’ve lost thousands of dollars in value. I knew that January’s returns couldn’t be sustainable and I expected some weakness in the short-term, but I never would have imagined we’d see such a precipitous sell-off. 10% isn’t all that much of a drop, but the pace of the selling is what has taken so many by surprise. The pace, and the fact that the underlying fundamentals of the market seem to be in place. More than that, companies continue to beat earnings left and right, spurred on in large part by recently passed tax reform.

Prior to the sell-off, valuations were high. Market watchers had been highlighting this for years. However, ~18x earnings doesn’t quick represent irrational exuberance to me. After the sell-off, we’re seeing the S&P 500 trading just a tad below 17x. This doesn’t exactly represent stellar value. I would argue that ~17x is a full valuation. A full valuation might not be a strong buy signal, but I don’t think it should represent rampant selling either. My point being, market valuation doesn’t seem to be a likely candidate to spark a bear market at the moment. There must be some other issue.

Analysts have been playing the blame game all week. They’re pointing to rising interest rates. The U.S. 10-year has risen from ~2.5% to ~2.8 in the last month or so. Sure, the yield has surpassed several important technical levels, but at the end of the day, I simply don’t believe that investors who were eschewing fixed income at the 2.5% level are selling all of their equity and piling into treasuries because of a ~30 basis point move?

I understand the relationship between interest rates; as the risk-free yields rise, investors discount growth and pay lower premiums for risk assets such as equities. But, when looking at this relationship I still find myself asking, “Is a quarter of a point really that important?”

If yields had risen 100 bps then I would understand this volatility from a rising yield standpoint, but as we saw late in the week, interest rate sensitive sectors such as utilities out performed, signaling to me that the market’s primary issue is something else.

Throughout the week we learned about the short volatility trade that went terribly wrong for traders, especially for those who were levered into the trade. It seems odd that such an unknown asset class could have sparked record breaking volatility, but when I reflect on the week, I honestly think the XIV unwind had more to do with the market action than anything else.

Sure, the jobs report combined with slightly higher yields contributed to the unease in the markets, but at the end of the day, the economy is strong and I don’t see any systemic issues. What I did see was a broken market in terms of structural issues relative to the XIV destruction changing the momentum of the broader markets slightly, which was exacerbated by algorithmic selling. Passive investing has been all the rage and I think we’re going to find that when fear is absent, this will lead towards very docile markets (we saw this in 2017). However, when sentiment changes the algorithms sell indiscriminately.

The biggest fear here for me in the future is the potential onset of illiquidity issues in overall ETP market (which is worth trillions). If NAV’s get out of order due to high volumes of redemption requests would could see a truly broken market. This is all speculative, of course, but I hope regulators and market makers use recent volatility as a warning sign and take a look at the market’s underlying structure in this digital day and age.

But, all of this pain in the markets isn’t necessarily a bad thing. When I talk about indiscriminate selling, I’m talking about irrationality. Earnings have been great. Balance sheets are solid. Shareholder returns are pointing upwards. I wrote an article a week ago about Visa (V) giving investors a double dividend increase (which is relatively rare, most of the time companies increase on a predictable schedule) and low and behold, it happened again this week. My favorite railroad, Union Pacific (UNP), gave investors another double dividend increase on Thursday.

Management teams certainly aren’t signaling weakness with regard to their corporate outlooks. I have a hard time believing that babies aren’t being thrown out with the bathwater during all of this weakness which is why I’ve been spending a lot of time putting together a shopping list should the downdraft continue.

This shopping list bit brings me back to my original thesis when I started writing this piece: my January Passive Income Update. I got a little sidetracked during the beginning of this piece but I think recent market volatility really shines a light on the importance of a reliably passive income stream. My portfolio lost quite a bit of value during the last week or so as markets across the world fell more than double digits from their recent highs, but my dividend income stream continues to grow.

My cash position isn’t particularly large because I came into the year fully invested and recently dipped into my cash to pay my wife’s graduate school tuition. It’s during times like this that passive income become even more important. I want to make moves in the market but I also don’t want to totally deplete my cash holdings which would limit my flexibility in the markets moving forward should they continue to sell off.

When looking at my dividend income in January I was pleased to see that they increased 52.26% y/y. This is fantastic growth, though I admit that much of it is not organic. I was deploying a lot of new money throughout 2016 and early 2017. I expect that my y/y gains will begin to flatten out (on a relative basis) throughout 2018 as I begin to rely more and more on organic growth (re-investment and dividend increases). In 2017, my dividend income was up 76.98% on the year, so we’re already witnessing this slowdown occur.

​I’ve discussed this before, but due to our current one income situation while my wife is a full-time student again, re-investment will likely slow in 2018. I don’t like the idea of withdrawing funds from the account, but I may have to use some of the passive income that my portfolio generates to pay for bills/the mortgage and/or bolster my cash position as I dip into it to pay for tuition. That’s okay though. I’m grateful for the financial flexibility that my passive income stream affords me; I’d much rather be withdrawing dividend cash than selling shares to raise capital.

In January I only made one dividend re-investment; I added to my Activision-Blizzard (ATVI) position that I’ve been building with selective re-investment in one of our retirement accounts. I expect to put my of my income stream to use in February because of the recent weakness that we’ve seen in the market. This more selective selective re-investment will likely be the trend for 2018; in the past I’ve felt strongly about dollar cost averaging regardless of market conditions but because I’m a bit more cash strapped than usual at the moment, I will be more conservative when I’m picking and choosing my spots in the market since I know I may need that cash for everyday expenses in the near future.

January 2018’s total was higher than all but 4 months in 2017. What’s more, it was a higher total than any one month in 2016. I began tracking my monthly dividend income back in 2014 and 4 years later, my January total was nearly 5x as much as it was back then. This shows great progress. This shows that the plan is working and gives me peace of mind throughout market volatility, knowing that I’ve taken another step closer to financial freedom.

disclosure: I am long V.

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