December 29, 2014
What We Got Wrong in 2014
- Higher interest rates would have meant challenging the stock market’s ascent, so we took action to protect portfolios, but, thankfully, it turned out to be insurance that we didn’t have to cash.
…the same as most everyone else. We, and seemingly the rest of the world(except for literally one analyst that we found, and our CIO flew across the country to meet with him after his stunning contrary call proved to be true) thought that U.S. interest rates would go up. But the 10-year Treasury Note ended up one full percentage lower than what BMM, and the consensus, thought. Higher interest rates would have meant challenging the stock market’s ascent, so we took action to protect portfolios in the middle of the year by reducing beta, but that action offered no alpha. In other words, we tried to protect your portfolio from a stock market drop, but it turned out to be insurance that we didn’t have to cash. Thankfully.
On the subject of capital preservation, what went wrong for advisors who protect wealth by managing a diversified portfolio, in 2014 that diversification offered no risk management benefits and was, in fact, a drag on performance. The big winner for 2014 was the S&P 500 large-cap U.S. stock market index. The standard inclusion foreign equity, small caps, etc. a) dragged down performance relative to the S&P 500 and, b) offered no meaningful volatility reduction as the S&P 500 barely corrected in price in 2014.
What We Got Right in 2014
There is a saying in this business that you can pick either the price, or the date, but not both. That being said, other than the interest rates defying the consensus and BMM offering portfolio insurance that didn’t need to be cashed in (figuratively speaking), we thought our calls were rather spot on. But the most important call in 2014 has been our most important call for the last half-decade – the U.S. stock market hit a generational low in March 2009 and is now in a secular bull trend.
2015 Global Economic Outlook
- BMM expects global growth to pickup modestly in 2015
- Despite tightening by the Federal Reserve, monetary policy will remain accommodative across the globe
- Improvement in global economic conditions is supportive of BMM’s expectation of a positive environment for equities
Global growth is predicted by the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) at 3.8% and 3.7%, respectively. These growth rates are moderately above 2014’s projected 3.3%, and slightly better than global economy’s average of 3.5% since 1980. While BMM is concerned about the risks of deflation in the Eurozone as well as geopolitical tensions, we find these forecasts to be reasonable expectations as we anticipate that all major developed economies will contribute to growth next year, led by the U.S.
One reason we lean toward agreeing with these projected growth rates is that the OECD’s Global Composite Leading Indicator recently rose to an eight month high, above its long-term average. This composite index argues that it is very unlikely to see a global recession next year. Strengthening this interpretation, the breadth of global growth is strong. Seventy-one percent of individual-country Purchasing Manager Indices (PMIs) are in expansion territory. Typically, the breadth needs to drop below fifty percent to hint at global recession. Additionally, this global expansion is only twenty months old. Since 1980, global economic expansions have lasted an average of thirty months (the longest at 57, and the shortest at 15). History, combined with leading indicators, argues that this global expansion is closer to its middle than its end.
The perceived threat to global growth in 2015 is that the U.S. Federal Reserve is poised to raise interest rates in response to stronger and broader economic strength. However, global monetary policy will remain easy next year. By most measures, aggregate global central bank interest rates are near an all-time low. Any rise in rates by the Fed will be at least partially offset by additional easing by the European Central Bank (ECB), the Bank of Japan, (BoJ), and the People’s Bank of China (PBoC).
-U.S.: Most components of Gross Domestic Product (GDP) should have good growth in 2015. The nearly five-year old recovery in the U.S. has been weak, as compared to GDP and payroll growth of past expansions. Evidence argues that 2015 will be a good year, but only relative to the past five years (low-two’s). This historical average of U.S. GDP growth is 3.3%; with luck U.S. GDP will be in the high-two’s in 2015. The current Blue Chip survey is at 3%, but we feel that’s just a tad bit optimistic, though not unrealistic.
A U.S. GDP growth rate in the high-two’s would be supported by continued healthy payroll gains, and favorable credit conditions even as the Fed raises interest rates. High-two’s is slightly better than the projected 2.4% growth for 2014. That moderately better growth expectation is anticipated due to improvements BMM has seen in ISM Manufacturing and non-Manufacturing indices, the growth rates of the Conference Board’s Coincident Leading Economic Index & the Philadelpha Fed’s U.S. Leading index, and the ECRI index.
The outlook for U.S. manufacturing had already appeared to be bright for next year, but dramatically lower commodity prices in recent weeks (although they are likely transitory price fluctuations as they have been known to be very volatile) will strengthen that outlook due to lower input costs.
Interestingly, the third year of the four-year Presidential Cycle (as is 2015) is historically a great year for the stock market as stimulus initiated in the prior two years began to actually gain economic traction. This time, in 2015, an economic boost should also be present, just coming in from a slightly different angle. State and local government budgets are in much better shape than in the early stages of the recovery. Their spending has increased in six of the last seven quarters, and that trend looks to continue, thus bolstering U.S. economic growth. With fiscal tightening (ala the sequester) already priced in, the government sector should move from being an economic drag to a moderate economic contributor.
The big risk to U.S. economic growth is that the Fed is expected to start raising interest rates in 2015. But BMM’s assessment of this is that the Fed is only going to do so because inflation is low, economic growth is strengthening, payrolls are improving, and thus, the U.S. economy is no longer in need of a hyper-easy monetary policy.
-Europe: The Eurozone started 2014 with great promise, but sputtered in the second half as the European Central Bank (ECB) president Mario Draghi failed to act as decisively as Dr. Ben Bernanke had in the U.S. Eurozone activity is mixed, which suggests that the economic region is in slow growth but not in a recessionary environment. The euro has been very weak; it has been the type of decline that is historically consistent with double digit export growth. This should help boost 2015 GDP growth to levels close to that of 2014, or about one percent.
-China: The prospects for outperformance by the Chinese stock market are still good. Last year investors were reluctant to buy into the attractive valuations of China’s stock market. However, since the low of October 2014, China has performed well, given a boost by China’s rate cut and move toward a more aggressive monetary policy.
The Chinese stock market has historically had a positive correlation to the price of industrial metals. Given the oversold condition of commodities, a run into 2015 is a high likelihood. The price of oil is also of consideration. As in the U.S., a drop in oil prices benefits consumer-oriented sectors at the expense of commodity-oriented sectors. Given that the Chinese economy is shifting from a capital expenditures world to one driven by the consumer, a permanent drop in oil is a long-term tailwind. But even if the drop is only transitory (which is most likely), there are short-term benefits. Three and six months after Brent crude oil declines of 20% or more, consumer-related sectors have accounted for six of the top ten performers, which is supportive breadth.
What Of Oil?
- Big commodity declines that occur outside of recessionary periods have been bullish for stocks
- Six months after oil has previously dropped at least 30%, the median advance for the MSCI All Country World Index (ACWI) is 11.6% (including both recessionary and non-recessionary periods). The six-months after has been challenging, seeing modest losses.
- If oil has hit a bottom, it suggests that the bulk of 2015’s gains may come in the first half of the year.
There has been a big decline in the price of oil. Big commodity declines that occur outside of recessionary periods have been bullish for stocks.
Big declines in the price of commodities tend to be associated with recessions. Of the six recessions since 1970, five have been linked to year-over-year declines of at least twenty percent. Before this year, there have only been four cases of such declines without a recession. BMM maintains that the odds of a U.S. recession are very low for 2015.
In the U.S., when commodity declines have been associated with drops of at least twenty percent (as measured by the S&P GSCI index), the S&P 500 median has been up a median of 8.8% 3-months later, and 20.2% 12-months later (compared to 2.9% and 7.1%, respectively, in recessionary periods). The sample size is very low, but it does suggest that so long as recession risks remain low, lower oil prices will be a positive for stocks.
Looking at the oil component of the S&P GSCi index specifically, we looked at thirteen prior periods where oil dropped at least thirty percent from a high. The bottoms of those drops are typically close to over at that point, but those types of drops typically take close to seven months – so while a bottom may or may not have been made, it could continue to be a bumpy ride for oil into Q2 2015. Six months after that bottom, the median increase for oil has been 23.9%, while the median advance for the MSCI All Country World Index (ACWI) is 11.6% (including both recessionary and non-recessionary periods). The following six-months has been challenging, seeing modest losses. If oil has hit a bottom, it suggests that the bulk of 2015’s gains may come in the first half of the year.
U.S. Stock Market Outlook
- The context of moderate U.S. economic growth suggests mixed sector leadership within the broader stock market uptrend. Sector leadership could flatten later, even if overweighted sectors only become less overweight.
- BMM has found that analysts are not very good at predicting earnings per share, but we are confident in our ability in of figuring out how much consensus estimates will move.
- The reward level for the S&P 500 in 2015 is 2,350; the risk level is 1,800. Based on the global economic outlook, hitting that risk level will be a function of an ordinary and regular correction that would be nothing more than a few months of interrupting the secular bull market.
BMM delivers all of its outlooks as a probabilities, but tends to deliver its outlooks without much of “on one hand this could happen, but on the other hand that could happen” conversation. This is done for two reasons, one of which is because listing all probabilities (and all the tangents that could then occur) would be, quite frankly, boring to readers. (But we do discuss those internally, of course.) The second reason is because while probabilities create shades of grey, there is no grey area allowed when managing an investment portfolio – either you buy or you sell. So we decide upon a probability, and then remain flexible as to expected outcomes – if the information changes, we need to change our minds.
Still, that does not mean an outlook cannot contain a range. For example, the optimistic reward level for the S&P 500 in 2015 is 2,350. But the risk level is 1,800. That’s about an equal gain or loss from current levels. If things go wrong, the stock market could end the year at the risk level and continue lower. But more likely, based on the global economic outlook, hitting that risk level will be a function of an ordinary and regular correction that would be nothing more than a few months of interrupting the secular bull market (not to sound cavalier about a ten-percent plus stock market correction but, quite frankly, that type of price fluctuation is not uncommon in bull markets).
The context of moderate U.S. economic growth suggests mixed sector leadership within the broader stock market uptrend. BMM weighted Financials and Health Care most heavily in 2014, and expect to do so in the early part of 2015. But sector leadership could flatten later, even if overweighted sectors only become less overweight.
As in past years, neither the reward level or the risk level are forecasts, per se, but rather probable prices should things go right, or if things go wrong, respectively. They are based on earnings and economic expectations, current valuations, multiple expansion possibilities based on standard deviations from the mean, etc, etc. Consensus estimates for S&P 500 operating EPS growth will grow from around 9.3% in 2014 to 13.7% in 2015. In almost every year in expansionary history, those start-of-the-year estimates have come down dramatically. For example, last year the 2014 consensus estimate was 12.6%. BMM has found that analysts are not very good at predicting EPS, but we are confident in our ability of figuring out how much consensus estimates will move. Estimates should decline next year, but absent an external shock, the actual decline shouldn’t be any more than what it is in any typical year. So EPS growth will probably be in the low-eight’s to high-nine’s for 2015.
The risk level could be hit for a short period of time if there is a correction (which there almost always is), and be part of a larger downtrend if economic conditions deteriorate. But BMM’s economic outlook argues for the reward level to be approached, even as the Fed raises rates and challenges stock market momentum.
The expectation is that at the Fed’s June 15-17 meeting (or maybe in September), the Fed will raise short-term rates for the first time in five years. This may concern some investors, but history has been more kind to the stock market around the first rate hikes than memory may serve. The S&P 500 has, on average, gone up 9.8% in the one year spanning the six months before and six months after the start of a Fed tightening cycle.
But the risk that no one is talking about is that in previous periods when the fed raised interest rates, they were responding to an overheating economy. The good news, of course, is that the Fed will not be trying to blunt excesses this time. Rather, their move will be because growth has hit the oft mentioned “escape velocity”, or the pace of growth at which the U.S. economy can continue to expand without the current zero interest rate policy. The risk, then, is the unknown.
While we should all be glad the Fed isn’t trying to slow things down, this normalization process is new. This is particularly important from the perspective of trying to select sectors, as identifying historical sector leadership going into the Fed’s first rate hike will be less meaningful. For example, while we are likely to flatten positions, we are – for the most part – overweight financials. However, a modest pickup in economic growth should help loan volumes, despite a flatter yield curve.
With much of the developed nation in an easing policy, a normalization of U.S. interest rates should continue to drive the U.S. dollar higher due to interest rate divergences. A strengthening dollar helps US importers, and is a headwind for US exporters, and puts downward pressure on commodities (which begins to explain some – but not all – of the downward pressure on the price of oil). The takeaways here are 1) we’re closely looking at where to put your money, 2) we will maintain current overweight positions, and 3) all positions are on a short-leash as we’re entering new interest rate territory.
Bottom Line for 2015: Aggregate foreign and domestic GDP should exhibit moderate growth. The big drop in oil prices should prove to be transitory, but remain a tailwind for the first half of the year. The perceived threat to global growth in 2015 is that the U.S. Federal Reserve is poised to raise interest rates in response to stronger and broader economic strength. However, by most measures, aggregate global central bank interest rates are near an all-time low. The reward level for the S&P 500 in 2015 is 2,350; the risk level is 1,800. Based on the global economic outlook, hitting that risk level will be a function of an ordinary and regular correction that would be nothing more than a few months of interrupting the secular bull market.