Forecasting? Often a fool's errand at best. Consider the tragic tale of DEC.
Throughout the 1970s, the leading American computer technology firm was Digital Equipment Corporation (DEC). At its peak, DEC was the world's second-largest computer company. Employing more than 100,000 people. Led by its founder, Ken Olsen, a former MIT computer engineer.
In 1974, a DEC research team approached Olsen with two prototype microcomputers. The world remained ignorant to the notion of personal computers. Olsen, seeing little utility in these devices, chose not to proceed. Even rejecting another PC proposal in 1977. Soon thereafter, MIT's Altair gave birth to the personal computing revolution.
By 1998, what remained of DEC was sold to Compaq. Soon after which the firm ceased to exist. Because one brilliant computer scientist failed to forecast the future of computing.
Two lessons here.
First, forecasting is a fool's errand best left to meteorologists and gamblers. Second, one is better off pursuing multiple trend lines and hedging bets. Jeopardizing everything by choosing one path can lead to rags and riches. Accordingly, it is best to play the long game and hedge. This best done by determining all possible outcomes and pursing the most likely. Such an approach may not lead to victory every time. But it keeps you in the game.
Investors approach this by the diversification of capital across multiple asset classes. While an investor may allocate more to those he favors and less to those he doesn't, he rarely avoids them entirely.
Warren Buffett, sage he is, has frequently underscored the importance of capital allocation to both investors and businesses. Buffett explains that capital allocation decisions should be based upon four commonsense questions:
1. The probability of an outcome occurring.
2. The amount of time the capital will be tied up.
3. The opportunity cost of not allocating elsewhere.
4. The downside should one's bet prove incorrect.
That said, we made a number of asset allocation determinations in 2014. Some of which worked. Some of which did not.
We were bullish on:
-Domestic equities... right
-Developed foreign equities... wrong
-U.S. corporate spin-offs and buy-backs... right
-Corporate fixed income... right
-Shale gas and oil... wrong
-Data storage and computing technologies... right
-Healthcare and biotech... right
-Consumer discretionary companies tied to a housing market recovery... right
-Geopolitical turmoil... right
We were bearish on:
-Commodities and commodity stocks... right
-Treasury inflation protected securities... wrong
-Long-dated Treasuries and government bonds... wrong
-Emerging market stocks... right
-Hedge funds... right
2014 saw lackluster returns overseas as European and Asian stocks struggled. Matters were only compounded by a stronger U.S. dollar. Small cap U.S. stocks were unmotivated. Though their large cap peers more than made up for it by returning nearly 14 percent on the backs of PE multiple expansion and earnings improvements.
We benefited by overweighting technology, real estate, healthcare and biotech. Avoiding emerging markets. And allocating capital to individual names like Apple, NXP Semiconductors, Visa and Gilead Sciences.
So, how will 2015 differ?
First, this year will lack the political brawl that was last year's midterm election. Supplanting the vacuum left by that three-ring circus will be:
1. Continued infighting within the euro zone as the southern Mediterranean economies seek debt leniency from their northern overlords.
2. Ongoing military and foreign policy debate regarding the most effective means of dealing with the growing threat of Islamic radicalism.
3. Constant anxiety over the Fed's timing of its determination to raise the Federal funds rate.
Second, as 2014 was so predictable, we believe 2015 may include a number of surprises for investors. The first four of which would positively impact equity portfolios:
1. The Fed will delay its decision to raise the federal funds rate until 2016.
2. Europe bolsters its nascent U.S. style stimulus program.
3. China's GDP growth accelerates, elevating commodities-driven emerging market economies worldwide.
4. The dollar, which has recently displayed signs of a topping pattern, may stabilize and fall.
The next six of which would negatively impact portfolios:
1. Stock market volatility, as measured by the VIX, was below 15 for much of last year. Largely due to massive amounts of global liquidity. But the closer we get to a liquidity sponging rate hike program, the more volatility will jump. Investors have wholly acclimated to the Fed's zero interest rate policy. Once terminated, expect some lofty spikes in the VIX.
2. Amid escalating violence in Ukraine, Putin's Russia sits on the brink of an economic disaster. Western economic sanctions coupled with plunging oil prices have crippled Russia's economy. The ruble fell more than 40 percent against the dollar last year. Putin, a classic autocrat, is not accustomed to being portrayed as weak. Thus the chances of his doing something to distract from his domestic troubles has increased. An invasion of Ukraine? Latvia? Estonia? Any would likely bolster domestic support and drive up the price of his treasured oil reserves.
3. With economic growth on the wane, China's woes have been widely discussed. Three years ago, GDP was growing 10 percent per year. The Conference Board recently predicted that could slow to 3.9 percent. Lagging Chinese demand has hurt economies in Australia, Africa, Germany and Latin America. Should it continue, Chinese domestic turbulence could rise. With the pain eventually impacting the U.S. economy, as well.
4. U.S. equity valuations have become lofty. And when stock prices become overly expensive, they stall or fall until intrinsic values catch up. The Shiller P/E values the market at 26. Well above its century long average of 16. And close to where markets have corrected in the past, with the Shiller P/E having reached 27.5 immediately before the 2008 credit crisis. True, the Shiller P/E has gotten higher than current levels. Much higher. But not very often.
5. Having resorted to American-style QE, Europe continues to struggle. The continent suffers from high unemployment, deflation, not to mention the existential issue of the E.U.'s survival. Recent issues in Greece have pushed the euro to its lowest level against the dollar in a decade. Should this continue, it could eventually flood U.S. economic gunwales.
6. A year ago, discussion focused on U.S. energy independence. Today, oil prices have been cut in half. There's simply too much of it. Largely the result of the U.S. shale boom and declining global consumption. Falling prices, once thought a boon for consumers, have cost some American jobs and hurt the stock market. Should the glut-driven price decline continue, expect to see U.S. job losses and worsening labor data.
Considering the above-detailed macro possibilities, what areas of the market should investors favor in 2015?
Attractive Themes for 2015
To start, realize that the primary objective with every client for whom we invest is the preservation of capital. As Warren Buffett said:
Rule number 1: never lose money; rule number 2: don't forget rule number 1
That is not to say that portfolios won't, on occasion, decline. Markets fall. As do their individual components. The challenge lay in constructing portfolios that, in aggregate, are built to withstand the macroeconomic headwinds that lay in wait. We believe the following ideas will benefit investment capital in the year ahead.
Last week's missive provided 11 reasons we like Treasurys (here). Chief among them? Treasurys continue to represent a safe haven for global investors seeking to allocate increasing liquidity amid rising volatility.
Consumer Staples and Food Stocks
These low-valuation defensive positions are the items purchased regardless of economic circumstances. Utilities, healthcare and consumer staples. Coming off positive 2014 trends, they continue to pay hefty dividends and offer better-than-average value.
Select Income-Producing Securities
Municipals and investment-grade corporate bonds rallied in 2014. We believe that continues into 2015. Also, look towards utility stocks, select REITs, and other stable, high-dividend securities. With U.S. equities in pricey territory, we believe investors should buffer volatility via safe and consistent income streams.
Select Healthcare Stocks
These will benefit from the increasing healthcare requirements of the nation's largest generation to ever fully retire. Not to mention the newly insured now covered by Obamacare. Medical office properties and the REITs that hold them are also attractive with doctors leaving private practice and migrating to hospitals in mass.
Small Consumer Luxuries
Even in crisis, global consumers continue to buy small-but-beloved, low-priced luxury items. Global consumer product specialists like Proctor & Gamble have found that emerging market consumers with static incomes and little discretionary earnings continue to pay more for fancier hygiene products.
Productivity Enhancement Tools
Software and technology that enhances productivity will continue to thrive as slow sales growth keeps businesses focused on cost-cutting and productivity enhancement. Those companies whose products can enhance bottom lines while helping to avoid additional labor costs will remain attractive.
Cyber Security Stocks
Following the recent Anthem hack and a rash of other high-profile customer data breaches, cyber security firms--which have already been hot--will continue shooting higher. Careful on valuations, as some of these plays have already seen valuations leap higher than income statements would justify. But, there are a few companies working for both the public and private sectors that we believe represent dynamic, long-term positions.
Ever consider that the recent plunge in oil prices represents more than Saudi attempts to shut down U.S. shale drillers? Alternative energy analysts believe that inexpensive solar energy is right around the corner. Soon enough, U.S. solar companies may be able to provide public and private customers with solar power at 5 cents per kilowatt hours. When that occurs, it will change the energy landscape. And with solar energy indexes bouncing off their lows yet 85 percent beneath all-time highs? The upside potential is exciting. We believe there will volatility along the way. Maybe even later this year. But this is a longer-term play. One worth every investor's attention.
Dollar-Hedged European and Foreign Equities
As U.S. equities become more expensive, so diminishes their expected returns. We like to consider the Shiller P/E, which shows today's price over the trailing 10-years of earnings. This tends to smooth out anomalies and provide a more realistic valuation assessment.
With the eurozone committed to stimulus and economic growth levers, we've already seen European equities hit seven-year highs. But, with the U.S. dollar continuing to rise against most foreign currencies, you're better off allocating capital to dollar-hedged European opportunities. Because, even as we expect European stocks to elevate, so too will the dollar.
Now, there's a caveat. While these stocks offer attractive valuations and mouth-watering dividends, many are contending with deflation and slow-growth economies. So, patience is required. But, as the situation overseas begins to stabilize, the opportunities will be dynamic.
Regarding U.S. equities, the Shiller P/E stands at 27.53. Historically, when that ratio was between 25 and 30, the index delivered a five-percent annualized return, roughly. The 100-year mean Shiller P/E for the S&P index is 16.58. So, the index is pricey.
That said, U.S. equities could still run up the next few years. Especially if foreign economies improve. Still, we see better valuations in Europe and the U.K. Albeit with slower current growth prospects. For instance, the British iShare pays an eight-percent dividend and provides a lower P/E, lower price-to-book ratio, and a lower price-to-sales ratio than the S&P 500. The same can be said for much of the eurozone. At some point, these will be great opportunities.
To better understand the power of investing overseas, a global equity portfolio provided a better rate of return with a lower standard deviation than did the S&P 500 from 1970 through 2013. In fact, $1 million dollars invested overseas became $128,393,142 during that 43-year period. Whereas the same $1 million invested in the U.S. equaled $88,750,665.
Bottom line? While we currently overweight U.S. equities, foreign equities--specifically those in the eurozone--will become opportunistic in a hurry, especially should recent stimulus efforts begin to pay off.
Unattractive Themes for 2015
Every year entails winners and losers. The adroit investor seeks to overweight winners while under weighting losers. While the U.S. economy remains a bright spot, many other developed economies are battling slow growth, terrible demographics and deflation. Accordingly, the concentric ripples will be felt throughout the global investment pond. The following areas are those we believe will face difficulties in 2015.
Copper, nickel, natural gas and crude oil will continue to present negative risk-to-reward ratios for the foreseeable future. As will the emerging market economies that heavily depend on them.
Emerging Market Stocks and Bonds
While valuations metrics are attractive, the macroeconomic picture for most of the emerging world remains troubled. Countries that rely on oil and commodity exports will remain under pressure. Tellingly, economic weakness will negatively impact returns on the government bond prices, as well.
Following a pickup in volatility last year, junk bonds have settled and are reappearing on buy lists. While a small allocation is warranted, we believe that those reaching for that easy yield stand to get burned. Weak shale producers and consumer discretionary concerns make up many of the bonds held in these indexes. Roiling issues in the energy sector and continuing U.S. economic concerns will hold these opportunities in check.
While the sector has suffered greatly, we believe that continuing macroeconomic drivers and ongoing efforts from Saudi Arabia will prevent these shares from regaining recent lofty heights throughout much of the year. And don't forget our thoughts on solar.
Private Equity Stocks
While we have profitably invested in publicly traded private equity companies for a while now, that window of opportunity is closing. Once the Fed begins to remove the liquidity punch available via ZIRP (zero interest rate policy), these deal makers will not have access to bottomless pools of cash with which to cut deals and make investments. Till then, however, we will continue to enjoy their price appreciation and meat-sandwich dividends.
We anticipate 2015 to present continuing opportunities for investors. Though with lower appreciation potential than recent years.
Investors oft forget that the S&P 500 went nowhere for fifteen years. Finding itself in exactly the same position in 2000, 2007 and 2014. Only last year did we break through the previous technical ceiling to achieve new highs. Thus, the market's latent energy has been released. It will continue to attempt higher highs. With only the poor government policy, global economic downturns and exogenous geopolitical events standing in the way.
Keep your stops tight and your head on a swivel. Yet, stay rationally optimistic. For that is always the surest path to health, wealth and happiness.