The New Year brings a sense of new beginnings, new resolutions, and new hope for good things to come.
On Wall Street, it also heralds an annual parade of predictions for the coming year, with great fanfare and hype, usually in the form of a “Top 10” list.
Most of these projections tend to be closely clustered around a consensus opinion and are not terribly bold or insightful. They typically call for slow growth, rising markets and an extrapolation of current trends and conditions.
And more often than not, this is what happens in broad-brushed terms. Economies and markets do tend to grow and rise over time.
But they are also prone to periodic setbacks, stumbles and worse. And, rarely do things play out according to conventional wisdom and prediction.
Widely held beliefs have a humbling habit of being turned on end, especially when held with great certainty by a great number of people with a great amount of money.
It is therefore instructive to look at what was widely held to be true in the past and how things actually played out, and to consider what is widely believed to be true today about tomorrow. History suggests that things will turn out differently.
For example, last January, it was widely believed that U.S. interest rates would rise. Instead, interest rates in the U.S. and around the globe fell to significantly lower levels. Long-term treasury bonds, the investment that most investors would have predicted to be one of the worst performing asset classes at the outset of 2014, was actually one of the best, up over 30%.
It was also widely believed that the “Energy Renaissance” in this country was a source of great new hope and promise (it still is) and the reason why investors scrambled to allocate ever larger amounts of money into energy-related investments.
Then in June of last year, oil prices began to fall, and kept falling, dropping over 50% between June of last year and today. (Chart 1) Investors started fleeing the energy sector like rats off a sinking ship.
It turns out that all that investment in oil production, as well as other factors such as slowing global demand, was resulting in an abundance of oil. Who would have thunk it? Suddenly, the reason why everybody wanted to be invested in energy became the very reason nobody wanted to be invested in energy.
Similarly, several years ago, gold was a much cherished asset class, a sure hedge against the pervasive money printing and currency debasement (also known as “Quantitative Easing”) by central banks around the globe.
The decline in value of the dollar and onset of inflation were considered to be inevitable, and money piled into gold driving the price to over $1,900 an ounce in 2011. (Chart 2) Instead, the dollar started a multi-year surge in value against most other currencies, and as investor concerns turned from inflation to deflation, gold prices began to fall and investors abandoned their precious metal in droves. Gold today trades for about $1200 an ounce, down 40% from it’s peak.
And, of course, up until 2007, real estate was considered a low-risk, sure thing investment. After all, historically, housing prices almost never declined. This belief became a religion that engendered increasing investment, speculation and overconfidence, and we ended up with a massive surplus of houses and debt. And then prices began to fall and things got really ugly.
Strategists at the beginning of 2007 projected slow growth and stable markets for the coming year, just like the year before that and the year before that. Most never saw the financial crisis coming until it was already upon them.
This is not to say that the crowd is always wrong, especially when consensus opinion is grounded by fundamentals. As we noted above, despite occasional setbacks, economies and markets have an upward bias towards growth and appreciation.
But, underneath the covers of overall global economic growth, the progress and performance of various economic regions, sectors and asset classes tends to be considerably more cyclical and prone to wide swings in investor sentiment.
This is the reason why diversification is so important. It pays to diversify against what you believe today, because the chances are good that the future will play out differently.
This is shown in Chart 3 above, which ranks the annual return of 11 different asset classes over the past 10 years. The fact that it looks like a quilt is indicative of how variable the performance of asset classes tends to be from one year to the next, both in absolute terms and relative to other asset classes.
The chart also proves the virtue of diversification versus putting all your eggs in one basket and/or chasing past performance. Suppose that on January 1st of each year, you put all your money into the best performing asset class from the prior year. After doing this for 10 years, you would have lost almost 15% of your money. If you had instead put your money into the worst performing asset class, you would have made 55% over the 10 years. And if you had put your money into a diversified portfolio allocated among the various asset classes, you would have made 101% and had a much smoother ride along the way.
And so, as we look to the year ahead, it is interesting to consider our investment outlook in the context of current consensus opinion.
The most commonly held beliefs for 2015 are that: 1) relative to most of the rest of the world, the U.S. economy is in the best shape and the place to be; 2) that the dollar will continue to gain strength against most other currencies and especially the Euro, and 3), that the overall pressures in the global economy are much more deflationary than inflationary, and that the outlook for commodities is generally negative.
There is more divided opinion as to the direction of interest rates, oil prices and whether Europe and Emerging markets are inexpensive enough, relative to the U.S. to offer an attractive opportunity for investment despite their problems.
We agree with the consensus that, relative to the rest of the World, the U.S. economy continues to have the most going for it. Economic growth is still suboptimal but moving closer to its longer term average of 3%, with little or no inflation (especially now thanks to the decline in oil prices).
Employment is also getting steadily better, with almost 11 million jobs created since the trough of the crisis, and the unemployment rate once again below its historical average of 6%. Wage growth has been gradually improving and should get steadily stronger. The U.S. private sector is in good shape having reduced debt and increased savings and investment. Business and consumer confidence continues to be strong. Meanwhile, interest rates are near historical low levels providing cheap capital for new investment. Moreover, the U.S. remains at the center of innovation and new wealth creation with a vibrant entrepreneurial culture. Hundreds of billions of dollars of economic value have been created by companies that didn’t exist 20 years ago.
Finally we are entering the third year of the presidential election cycle. Although we have all managed to reduce our expectations for elected officials, and they always seem to fall short none the less, this is typically a positive year for the U.S. stock market; a time when we allow ourselves to believe that good solutions and forthright leadership might again be possible and just around the corner. Historically, since 1929, returns during the third year of a presidential election cycle have been almost double the average of any other year. Hope springs eternal.
There are always clouds on the horizon. For the U.S. economy, there is the prospect the Federal Reserve (aka “the Fed”) will finally start to raise short-term interest rates. We do not see this as a big issue. Even if the Fed raised rates by several percent, they would still be low by any historical standard. Meanwhile long-term interest rates keep falling. This is more concerning to us.
There is also the challenge of slowing growth outside of the U.S., which will put a damper on U.S. exports, especially if Europe falls back into a recession.
Likewise, a stronger U.S. dollar makes U.S. exports less competitive in a global economy and reduces the value of foreign currency profits. We expect the dollar to keep appreciating relative to most other currencies and especially the Euro.
And there are always the unexpected events from left field that throw everyone for a loop.
At the moment, the markets are fretting about the rapid fall in oil prices. Some worry that it is a harbinger of a new global downturn, corroborated by deteriorating economic fundamentals outside the U.S. and falling bond yields almost everywhere except Greece. Some also worry that it will put a damper on economic growth since it will impact energy-related investment and employment.
But we view the decline in oil prices as an unambiguously good thing for the U.S., Europe and every other economy for which energy is a major input cost.
We also believe that price decline is more a result of excessive financial speculation being unwound than a true indication of current fundamentals.
Europe continues to suffer from an economic case of walking pneumonia, teetering in and out of recession. Unlike the U.S. which combined aggressive fiscal stimulus and monetary intervention to jump-start the economy and take up the slack from the private sector, Europe did neither, choosing fiscal austerity over stimulus, combined with reluctant monetary intervention. This has resulted in a deflationary environment where private sector contraction has been matched by government contraction, rather than countered by government spending.
There are high hopes that Mario Draghi and the European Central Bank will finally step in with a massive amount of monetary stimulus, but this will be difficult without unified support by member countries and especially Germany. So far, this seems like a stretch, especially with problem members like Greece starting to act up again about defaulting on debt and/or leaving the Euro-zone.
The Emerging Economies are also slowing, although still growing, and are very much of a mixed bag. As we noted above, the fall in energy prices is positive for oil importers like China and India, and a negative for exporters like Brazil and Russia.
We still believe that over time, the majority of global growth will come from the developing, rather than the developed world. It is therefore important to have investment capital allocated to the developing world, but we are focused on the growth of large consumer markets, especially throughout Asia, and less on resource-driven economies.
Putting it all together, the U.S. economy and stock market appear to be the nicest and most expensive house in a somewhat troubled neighborhood.
U.S. stocks are fully valued but not excessively so. Stocks can stay at higher valuation levels for years and certainly have the potential to go to higher levels as investment dollars flood in chasing performance. This happened in the last half of the 1990’s and could easily happen now.
But a more expensive stock market is also a riskier stock market, more prone to volatility and vulnerable to shocks and setbacks. For U.S. stocks to appreciate meaningfully and sustainably from here, we need to see a significant boost in economic growth as well.
Europe and Emerging markets offer the appearance of greater value, but with greater challenges. Also, there are important differences between the composition of the U.S. stock market, which is more heavily weighted to technology and growth, and European and Emerging markets, which are more heavily weighted to slower growing financial and industrial companies that tend to command lower valuations levels.
We continue to take a global approach, focusing on faster growing companies throughout the developed and developing world.
We still think that bonds offer poor long-term value for the money relative to stocks and the inevitable prospect of higher interest rates. In the near-term, we think rates could move lower first. It is hard to see what would drive U.S. interest rates higher when European and Japanese rates are considerably lower (and they have significant problems). But eventually, interest rates will rise, most likely just when the crowd has come to the conclusion that this cannot possibly happen. Then, the surprise might be just how far and fast they rise.
As always, we welcome your questions and comments.
Jurika, Mills & Keifer, LLC