Research & Advice

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Stages

Sunday, March 16, 2014

 

Market Risks and Rewards for 2014

(excerpts and updates from BMM’s Economic Outlook for 2014 report)

  • The list of good news for 2014 outweighs the list of bad news for 2014. The bad news, however, is meaningful.  The stock market could experience its largest correction since 2011.
  • Because any correction would be cyclical in nature, BMM will consider making minimal – if any – adjustments in investment portfolios. Of course, if we identify indicators that concern us of, say, a twenty-percent drop (such as stretched valuations, or rapidly deteriorating breadth) then we will be required to take more defensive action.
  • As to the question “how much”, the average risk for the possible iterations of the cycle is a 13% decline, or 1,638 points on the S&P 500.  The likely most bearish scenario is a twenty percent drop, down to 1,506 points.
  • Absent an outlier of the year ending on a high note on a specific calendar date, the returns for the global market likely will see low-to-mid single-digit return rates.

The list of good news for 2014 outweighs the list of bad news for 2014. The bad news, however, is meaningful.  The stock market could experience its largest correction since 2011.  To be clear, any 2014 correction – no matter the size – would be cyclical in nature and not upset the longer-term secular bullish outlook.  Downside damage will be limited, and quick, as investors – even with declining portfolio values – refocus on the resilience of the global economy.  This will launch a new cyclical advance, and revive the secular uptrend.

Because any correction would be cyclical in nature, Berkshire Money Management will consider making minimal – if any – adjustments in investment portfolios. Of course, if we identify indicators that concern us of, say, a twenty-percent drop (such as stretched valuations, or rapidly deteriorating breadth) then we will be required to take more defensive action.  If that is to occur, the next logical question might be, “when?”

While a sizable downdraft in 2014 is “due” and consistent with the U.S.’s mid-term year of the “presidential cycle”, the timing of such a move downward is difficult.  Though at sixteen months of trading above its 200-day moving average, it is easy to prognosticate that the timing would be simply “soon.”

 

As to the question “how much”, the average risk for the possible iterations of the cycle we are in is a 13% decline, or 1,638 points on the S&P 500.  The likely most bearish scenario is a twenty percent drop, down to 1,506 points.  The risk and the reward for the stock market will not be beginning to end, but rather during the year.  From start to finish, a moderate gain is expected for most global markets.

The reward for 2014, from start to finish, (with the luck of ending on a high note on one specific calendar date, New Year’s Eve) may be as generous as ten percent (more than the long-term annual return of the stock market, so quite a generous return for stock market investors who know stock market history).  But absent an outlier of the year ending on a high note on a specific calendar date, the returns for the global market likely will see low-to-mid single-digit return rates.

These types of scenario analyses provide a framework, but our objective indicators will tell us whether and when the scenarios are actually playing out.  Deteriorating breadth, rising interest rates, and worsening sentiment are potential drivers of a decline in the market.  Berkshire Money Management has never attempted to make year-end targets.  It’s an almost obligatory practice for financial firms, but it is useless in so much that getting it right not only depends on the luck of how the market closes on its last day of the year, but also because information changes.  And as information changes, we need to change our mind.  We need to change our considerations so as to best move client portfolios forward, but while maintaining our primary objective – preserving client capital.

A more silent risk, if only because it is a long-term risk, is that bonds will no longer offer the generous returns that investors have become accustomed to. Investors who were allocated “conservatively” over the last two, ten, even twenty years into bonds and bond mutual funds recognized not only income, but also appreciation.  Interest rates on bonds will go higher over the years to come, and prices will drift lower, forcing bond allocation into lower-quality bond products and eventually into equity.  For those who require a less volatile portfolio and the possibility of keeping up with the rate of inflation, bond allocations will require taking credit risk.

Economic Outlook

  • The US economy is poised for steady growth as headwinds begin to fade.
  • Beyond solely the US, the global expansion also remains intact, as developed countries lead the way in growth.

The US economy is poised for steady growth as headwinds begin to fade.  Severe winter weather across much of the country during December, January, and February has temporarily disrupted economic activity.  But beyond this seasonal impact, economic fundamentals remain strong and we expect the expansion to accelerate as the year progresses.  Fiscal policy has been mostly eliminated as a source of risk.  We expect Fed tapering to be removed at a steady, non-disruptive pace.  And inflation pressures remain subdued and below the Fed’s longer-term target.

In February 175,000 jobs were created in the US, the best reading in three months and rivaling the average 180,000 per month in 2013.  And while the estimate for fourth quarter Gross Domestic Product (GDP) was revised down to 2.4% from 3.2%, much of that blame can be placed on the aforementioned cold winter weather. The underlying fundamentals remain conducive for growth.  2014 will be a good year for the U.S., making it a major driver of global growth.  After five years of modest growth, we expect the US economy to gain some additional momentum this year.

Beyond solely the US, the global expansion also remains intact, as developed countries lead the way in growth.  One measure of the economic health of the manufacturing sector is the purchasing managers’ index (PMI).  The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.  In February the global PMI reached its highest level since April 2011.  It was the PMI’s eighth straight monthly gain, placing global manufacturing in solid expansionary territory for the last fifteen months.  The new orders portion of the PMI reached its highest levels in three years, suggesting a continued pickup in the coming months.

We acknowledge that forecasting by taking the recent and extrapolating into the future is an oft made mistake (in the industry, it’s known as “forecasting with a ruler” and it is why many people make mistakes at turns in the market).  But in this instance we can track an expectation of a turn in the global economy by tracking the breadth of the global PMI (i.e. determining how many countries are participating in the expansion).  One way BMM manages the volatility is to look beyond monthly changes in global PMI breadth and look at year-to-year breadth measures, which continue to look positive.

 

Stages

  • The case for a double-digit stock market decline has not diminished since we wrote our Economic Outlook for 2014 report three months ago.
  • Unless our indicators tell us that the risk of such a decline is actually rising (in terms of both starting point precision as well as magnitude) we will remain positioned for the continuation of the global market advance, with consideration of minor allocation changes reflecting relative market neutrality and/or sector and asset class changes (as opposed to how BMM moved to mostly cash and cash-like instruments in 2002 and 2008).
  • It now appears to be an opportunistic time to review individual portfolio holdings, ensuring that each issue is participating in the current market advance.  As a bull market matures, it becomes increasingly important to eliminate those holdings that no longer participate in the market advance.  Holding onto positions that are essentially ignoring the strength of the broad market is more risky now that the bull market is more mature, as opposed to when it was in its infancy.

The stock market started the year with a 5.8% and 7.3% pullback for the S&P 500 and the Dow Jones Industrial Average (DJIA), respectively, but February was a good month for equity gains, which brought both indices back to close to a few percentage points from recent highs.

So was the message from February’s market performance (the best February for the S&P 500 since 1998) that the warning of a volatile January can safely be ignored?  While BMM managed portfolios, ranging from conservative to aggressive, maintain their equity exposure, we are not ready to argue that a cyclical peak should be ruled out.  Why maintain equity exposure?  The current allocation of equity respects the long-term uptrend that started well before 2014, because it is a bull market until proven otherwise.

More downside volatility lies ahead.  As discussed in our Economic Outlook for 2014 report, “the risk and the reward for the stock market will not be beginning to end, but rather during the year.”  The price action of the stock market for 2014 is expected to be far less linear than 2013 and, instead, be defined by stages.

  • Stage 1 (January to April?) – Leading into a cyclical bull-market peak, this stage has been characterized by momentum, and a Growth bias over Value.
  • Stage 2 (April to September?) – A significant stock market decline characterized by relative out-performance of low-beta selections and dividend payers with reasonable valuations.
  • Stage 3 (September to December?) – Following a bear market bottom, the magnitude of the decline will be important in determining sector and asset class leadership, but high-beta selections and a mean-reversion theme are likely.

The case for a double-digit stock market decline has not diminished since we wrote our Economic Outlook Report three months ago.  But unless our indicators tell us that the risk of such a decline is actually rising (in terms of both starting point precision as well as magnitude) we will remain positioned for the continuation of the global market advance, with consideration of minor allocation changes reflecting relative market neutrality and/or sector and asset class changes (as opposed to how BMM moved to mostly cash and cash-like instruments in 2002 and 2008).

So why only the possibility of minor allocation changes as opposed to a more decisive change of tone?  Of course, there is the obvious consideration of precision timing (or lack thereof – i.e. there are not tools that offer precision as to timing the peaks and troughs).  Also obvious is that stock market corrections (corrections, not crashes) are ordinary and part of the market’s regular price movements (on average, there is a ten percent correction every fourteen months).  Not to sound cavalier, but it happens.  We will take much greater precaution if it appears the correction will be more significant.

But the biggest reason why allocation changes may be classified as more minor is that we do not expect the market pullback to be a crash, but a correction – an interruption to an ongoing bull market that, while experiencing it, is painful but otherwise quickly forgotten.  The most significant market pullbacks (in terms of both duration and magnitude) occur when there are significant economic headwinds, and those have been reduced.

But what if BMM’s economic forecasts are wrong and the US and global economy weakens considerably?  While BMM relies heavily on fundamental analysis (economic growth, earnings stability, interest rate variation, etc.), we also inspect what is actually happening in the stock market (the technical).

As a bull market ends, stocks do not all fall at once.  Rather, as a primary trend matures, more and more stocks fail to fully participate in the advance and fall into their own individual bear markets.  Even as a major stock market index, like the DJIA, the S&P 500 or the NASDAQ hits new highs, it’s possible that fewer and fewer stocks are responsible for lifting the entire index.  This process of selective selling is initially apparent through measuring 52-week New Highs and the percentage of stocks that are twenty percent or more below their highs. Then there are more advanced signs, such as lagging Advance-Decline (Adv-Dec) lines.  The point is, BMM has technical tools that often warn us before the fundamentals.

Thus, for an investor, it is important to attempt to identify a weakening trend that, eventually, will result in a new bear market. But as of today, rather than signs of selective selling, the Advance-Decline lines for all the major indexes have not only confirmed the bull market highs, but in several cases have moved to new highs ahead of their respective price indices.  These new highs have included the Adv-Dec lines for the mid- and small-cap indices, which are particularly important since the first signs of market weakness are often evident in these market segments.

But as we approach Stage 2, it now appears to be an opportunistic time to review individual portfolio holdings, ensuring that each issue is participating in the current market advance. With the consideration of our expected proximity of change from Stage 1 to a more volatile next stage, a review of a portfolio for a move from underperforming issues is important.  As a bull market matures, it becomes increasingly important to eliminate those holdings that no longer participate in the market advance, as the ability for an issue to be lifted by the broad market’s uptrend lessens.  Holding onto positions that are essentially ignoring the strength of the broad market is more risky now that the bull market is more mature, as opposed to when it was in its infancy.

 

Sector Considerations

Following please find some highlights of the major US stock market sectors.

 

  • Health Care – overweight

 

Sector Positives:

-The US’s aging population and eventual broader insured base

-Obamacare is a game changer; more money and more patients can hopefully outweigh more bureaucracy and price controls (four million+ signed up)

-Healthcare spending is expected to recover after stagnating during and post-recession

 

  • Information Technology – overweight

 

Sector Positive:

-Momentum

-Consumer spending on Technology categories remains healthy

-Undervalued on both a trailing and forward P/E basis

-High-tech industrial production growing faster than overall manufacturing

-Mobile trends strong

 

  • Consumer Discretionary – marketweight

 

Sector Positives:

-Easing lending standards and lower debt service burden is leading to expanding consumer credit

-Household net worth, and employment continue to improve

-Falling commodities and positive real disposable income growth

 

Sector Negatives:

-Forward P/E more than 1 standard deviation above average

 

  • Consumer Staples – marketweight

 

Sector Positives:

-Typically a decent performer mid-economic cycle

-Improvement in Europe could be a catalyst for multinationals

-Falling commodity prices and end of financial repression favors consumer sectors

-Relative forward P/E is reasonable

 

Sector Negatives:

-Expected growth rates for 2014 look low compared to other sectors

-Improving composite leading index (CLI) bearish for defensive Staples

 

  • Financials – marketweight

 

Sector Positives:

-Positive gross loan growth

-Credit conditions improving

-U.S. banks are flush with deposits

-Steep yield curve

-Improved commercial real estate conditions

 

Sector Negatives:

-Earnings impact due to financial reform

-Bank securitization window remains closed

 

  • Industrials – marketweight

 

Sector Positives:

-Business outlook optimistic globally

-About 80% of individual CLI components improving

-Nearly 80% of global PMIs in expansion territory

-Commercial & industrial loan growth reaccelerating

-Housing and nonresidential construction recovery

-Replacement cycles

 

Sector Negatives:

-Relative breadth mixed

-ETF outflows

-Expiration of bonus depreciation

-Federal government spending cuts

 

  • Materials – marketweight

 

Sector Positives:

-Sector undervalued

-Low Chinese inflation

 

Sector Negatives:

-Chinese growth being questioned

 

  • Energy – underweight

 

Sector Negatives:

-Weak relative strength vs. other S&P 500 sectors

-Economic growth worldwide remains relatively slow

 

  • Telecommunications – underweight

 

Sector Negatives:

-No pricing power

-Volatile ETF flows

-Unfunded pension liabilities

-Political (antitrust) and competitive (patent) headwinds

 

  • Utilities – underweight

 

Sector Negatives:

-Excess Capacity

-Regulatory headwinds for coal-fired generation

 

Bottom Line:  2014 is expected to see its biggest stock market decline since 2011. As we get closer to the start of this anticipated decline, it appears to be an opportunistic time to review individual portfolio holdings, ensuring that each issue is participating in the current market advance.   As a bull market matures, it becomes increasingly important to eliminate those holdings that no longer participate in the market advance, as the ability for an issue to be lifted by the broad market’s uptrend lessens

 

For both 2002 and 2008 BMM raised extremely high levels of cash and cash-like instruments as we anticipated market declines of major magnitude and duration.  Neither fundamental nor technical research argues for a mid-year decline to be the demise of the secular bull market that started five years ago, but it does promise to feel significantly disruptive to investors’ portfolios.  Unless our indicators tell us that the risk of such a major decline is actually rising we will remain positioned for the continuation of the global market advance, with consideration of minor allocation changes reflecting relative market neutrality and/or sector and asset class changes.