Cautiously Considering 2015.

January 14, 2015

2014 was a year of upheaval. Eurozone distress. A quelling of China's dynamic economic trajectory. Shaky Japanese economic policy. Turmoil in three of the five BRICS nations. Russia's Ukrainian incursion. Collapsing energy prices. The ascendance of ISIS. Crises in Syria. Iraq. Gaza. Hong Kong.
Yet, positive trends abound.
The U.S. economy appears to be on the upswing. Britain's posting steady economic growth. Markets have placed confidence behind the economic ambitions of new leaders in India and Indonesia. And China's economy appears to be tacking higher.
U.S. markets appeared unperturbed by geopolitical crises and macro economic setbacks alike. Stocks trickle ever higher. While the Fed's decision to tighten the purse strings could adversely affect that trajectory, we believe 2015 could be a solid year for stocks. Providing more opportunity for risk takers.
2015 GDP growth is anticipated to be roughly 2.9 percent. Earnings growth should be steady. Inflation should be muted. And rates will remain low for a significant amount of time. All of which will serve as tailwinds for stocks. Leading us to conclude that equities will remain attractive as compared to bonds.
If the above factors play out, and corporate earnings growth continues as we expect, then 2015 should be positive for investors. Moreover, if P/E expansion occurs due to interest rates remaining lower for longer than anticipated, then 2015 may provide even more upside potential.
Bull markets rarely end when P/E multiples sit at slightly better-than-average levels. Rather, bulls die when euphoric investors push P/Es to levels well beyond where they can be justified. One need only recall the heady days of 2000 and 2008. Such times give way to manic sentiments towards risk assets. Friends in all professions become amateur traders. Stock tips replace sports talk. We are not yet there.
In any given year, the stock market has roughly a 67 percent change of rising and so a 37 percent chance of dropping. 2015 included. Putting the odds in your favor.
Care for a means of judging the market's returns?
Historically, the S&P 500 provides a rate of returns roughly 600 points better than the risk-free Treasury rate. Accordingly, short of some negative event that steers markets markedly lower, one can assume the risk-free rate plus 500-600 points, adjusted per risk tolerance and asset allocation.
Given that we're nearly six years into a recovery, the market has a slightly more cynical feel than it should. Which, as we've long attested, will serve us well. For the stock market exists to disappoint as many investors as possible as frequently as it can. And so long as a plurality of investors believe the next shoe is about to drop, it won't. Allowing stocks to rise. And contrarians to prosper.
The biggest gift given this era's investors has been an omnipresent 24/7 news media dedicated to selling ads by scaring the hell out of anyone paying attention. So long as the public believes that Ebola, bird flu, measles, ecological disasters, spina bifida, economic catastrophe, labor uncertainty, drought, deflation, floods, inflation, wayward meteors, alien invasions, Al Qaeda, heroin addiction, meth affliction, ISIS, mudslides, European recession, solar flares, tsunamis, war, Asian depression, child predators, serial criminals, bad cops and the end of the football season lie around the next corner, this market can go higher.
This very moment, news anchors nationwide are prognosticating on the 50 percent decline in oil prices, and the obvious foreboding for the U.S economy. Only, the same scenario transpired in 1986. During which the Saudis, fearing a loss of market share to U.S. producers, flooded the market with oil. The price of which fell by 67 percent. Stocks cratered, right? Wrong. They jumped 18.5 percent higher. And rose another 5.2 percent the following year.
Conversely, the financial-apocalypse crowd is crowing about the Fed's oncoming interest-rate hikes. "As soon as we start raising rates, all of this liquidity driven growth will evaporate. Markets will be cut in half!"
Only, they fail to mention that the Fed typically raises rates because the economy has stabilized and appears to have achieved a level of sustained, ongoing strength. Which, of course, is positive for stocks. In fact, amid 17 consecutive Fed interest-rate hikes from 2004 to 2006, stocks rose at an annual clip of 16 percent.
And what about those rate hikes, anyway?
Last Friday's jobs report stood at 252K jobs created for the month of December, closing out a year in which both GDP and employment have improved markedly. The economy produced an average of 246K jobs per month in 2014. GDP grew at 4.6 percent in the second quarter and 5% in the third quarter. This infers that GDP may be accelerating. Unemployment, now at 5.6 percent, is approaching the natural rate. This leads some to believe that rates could move up in the first half of 2015.
That said, there's always the proverbial "wall of worry." The labor participation rate continues to fall. As does the size of the labor force. Average hourly wages declined 0.2 percent in December, and November's gain was revised down by half to 0.2 percent.
For the year, wage gains rose only 1.6 percent, as compared to 2 percent for 2013. This likely provides room for the FOMC to be patient about raising rates until labor markets improve. Especially since inflation remains below its two-percent target.
We believe that the Fed will be cautious and patient. For several reasons.
First, the committee consists of a dovish majority that is clearly more inclined to wait before acting, and in the past has been primarily concerned about labor market developments.
Second, given the low rate of inflation, there are reasons to believe that inflation will remain below the Fed's two-percent target for most of the year. The drop in oil prices has put downward pressure on measured inflation and will also help keep prices low in those sectors whose profit margins will accelerate simply because of the decline in a significant input cost.
Additionally, there are abundant sources of downward price pressure internationally. Europe is struggling.  Russia is in recession. China has slowed. As has Latin America. Geopolitical uncertainty looms large. And those risk perceptions were not helped by last week's terrorist attacks. These factors bring a flight to quality, downward pressure on bond rates, and growth in the dollar. All of which will keep prices low.
A third factor putting downward pressure on interest rates is the U.S. budget deficit. According to CBO estimates, the deficit declined from $1.4 trillion in 2009 to $506 billion in fiscal year 2014. It is projected to be a bit lower in 2015. The decline in the rate of increase in outstanding Treasury debt, mixed with increasing demand for collateral and safe assets, should bid up bond prices and lower rates. So, it does seem that labor market conditions, though important, will take a back seat to the Fed's inflation objectives where policy is concerned. Low inflation may provide the committee with a free ride for the near term. Allowing them to wait out the downside risks, geopolitical uncertainties and economic slowdowns in the rest of the world.
On balance, as we've oft stated the last year, we don't foresee any rate changes until September, if not well beyond then. Though that will not prevent the nattering blabocracy from discussing it incessantly.
Year after year, pessimists and their media counterparts seek that disastrous event that will break the market's spine. Because that sells newsletters, newspapers, magazines, books and documentaries. Hell, I admit to loving the stuff. Pending disaster is fascinating! But, like the movies, we must remind ourselves that the majority of it is not real. An illusion. The purple haze of our imaginations.
Nearly every year, investors prepare for the worst. And the optimists prevail.
Keep in mind the words of the indefatigable Winston Churchill who said, "The further back you can look, the farther forward you are likely to see."
Investors, like other classes of human beings, tend to extrapolate too much from recent experience. Failing to recognize that things often conclude much better than anticipated.
In post-WWII 1950s America, few would have thought that the stock market would return nine percent per year for the next half century. Last century alone, stocks survived two global military conflagrations, flu epidemics, countless regional wars and the financial default of numerous nation states. And yet. Stocks, bonds and other asset classes ploughed relentlessly higher. Propelled higher on the shoulders of progress, innovation, hard work and limitless optimism.
As noted in previous missives, 2014 was the year of the kitchen sink. As the investors contended with every conceivable issue. Still, amid the fear, flames and fury, the stock market climbed.
We would caution you, however. Do not be cowed into lethargy. 2015 will likely bring more volatility than the last few years have seen. Moreover, we've lately noticed bearish indicators.
The slowdown in growth overseas could reach crisis levels and spill over the domestic gunwales. And while a higher dollar usually helps stocks by lifting P/E multiples, this could represent that infrequent occasion when a rising dollar curbs demand for U.S. goods.
Lately, gold and the dollar have risen in tandem. This traditionally portends risking-risk aversion among investors. And while falling oil prices have historically been bullish, those times that stocks have sunk while oil prices drop have signaled that investors are bearish on global growth. Which tends to override improving U.S. consumer confidence.
Staying with oil, past price volatility has often preceded big market corrections and bear markets. 2008 being the most recent example.
Just because the road looks pleasant doesn't mean you should remove your seat belt. As investors, there is no room for complacency. For when we become complacent, we fail to notice the indicators. Like slowing growth. Which often leads to bad things. Like credit crisis. Currency crisis. And war.
As bull markets mature and valuations climb higher investors typically grow anxious. Like black jack winners who begin acting erratically. Unsure of whether they should quit while ahead or push their luck. Either way, emotions often get the best of them. This will occur, as 2015 pushes closer to that euphoric stage at which all bull markets implode. Accordingly, we will maintain a vigilante eye for a market top.
But, if the fundamentals remain strong, 2015 could be another solid year for well-diversified, rational, forward looking investors. Next week, we'll look at the intrinsics of the year ahead.
Till then, invest wisely.

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