Don’t Expect Low Market Volatility in 2015
History will remember the year of 2014 as “the year where markets would not cooperate with consensus.” Interest rates went down when they were supposed to go up. Europe declined when it was supposed to have been deeply under-valued. Japan failed to impress even as their leadership threw the kitchen sink at stimulus. Gold prices wouldn’t move even as monetary and geopolitical instability reached new highs. Oil prices collapsed despite elevated global demand. And through all of this, perhaps most bizarrely, broad equity markets added on yet another year of double-digit returns. This was not a good year to be in the consensus frame of mind.
Perhaps none of the above evidences of market stubbornness are more significant than the bond market’s behavior in 2014. The bond market is a powerful signal about the economy, about global risk, and about market forces. A ten-year bond yield just over 2% even as European and Japanese bond yields wallow below 1% tells you (if you are listening) that the economy is not as strong as many believe, and if it is, the bond market doesn’t believe it. Deflationary forces persist that are clamping down on global growth and bond yields tell you that if you don’t believe it, they are going to make you believe it. Corporate profits have continued to grow behind the miraculous efficiency of corporate America, allowing the stock market to create a narrative of its own. But at the end of the day, if robust GDP growth (domestically and/or internationally) were needed to drive U.S. corporate revenues and therefore U.S. corporate profits higher, one would think markets would have been sorely disappointed.
Tepid growth was the name of the game, where there was any growth at all. U.S. GDP growth was strong in Q2 and Q3 (and Q4 is expected to post a good number as well), but the horrid Q1 number (showing a contraction of over 2%) means the economy will once again post real growth well below 3%. When all is said and done, the U.S. 10-year Treasury yield began the year around 3% and ended the year around 2.2%, a stunning development given improved jobs data and GDP growth. The behavior of the bond market has to be considered one of the major surprises of 2014.
The stock market saw volatility pick up significantly in the fourth quarter of the year, but that volatility was elevated above unprecedented low levels. The S&P 500 briefly flirted with a 10% peak-to-trough drop (hitting momentarily a 9.8% decline from its high), but shook off many of the bearish cobwebs and managed to finish the year up 13.69%. Eight of the 12 calendar months proved to be positive on the year for the U.S. stock market, with Utilities and Health Care leading the pack (both with returns well over 20% on the year). Only the Energy sector saw a decline on the year (an 8% drop), this coming on the back of a 50% decline in the price of oil in the last several months of the year. Debate continues over how much of this violent decline is related to a glut of supply, how much is related to demand slowdown, and how much may be related to geopolitical posturing. U.S. profit growth was the primary catalyst for stock market growth in 2014, with earnings on the S&P 500 estimated to have grown roughly 8%. P/E ratios appear to be normalized, and a discussion on valuation is warranted as we enter 2015.
A trip down memory lane in 2014 is filled with irony and surprise. In January we saw tensions heating up in the Ukraine as Russia annexed Crimea against the protests of the international community. Turkey appeared near an economic catastrophe. U.S. GDP growth appeared to be collapsing. Jobs data was atrocious for the winter months. And yet within a few months, emerging markets had rallied substantially and all U.S. economic data had improved far more than expected. As the year progressed, the market shrugged off increasing tensions in Russia, Middle East instability (the rise of ISIS, Israel/Gaza turmoil, and ongoing uprisings in both Syria and Iraq). Threats of Ebola coming into the United States from West Africa dominated the U.S. airwaves late in the year, but had far more of an impact on media headlines than it did U.S. market behavior. The U.S. completed its tapering off of quantitative easing by the end of the year, and yet bond yields dropped even further. It would be very difficult to take the headlines of 2014’s news cycle and match them to any detectable market behavior.
THEMES TO CONSIDER IN 2015
Convergence vs. Divergence
A theme we expect to take front and center attention in 2015 is that of the diverging economies amongst major developed countries, and the diverging policy prescriptions various policymakers will institute. The positive growth of the U.S. economy stands in contrast to many other parts of the world, whereas Japan is experiencing contraction and Europe is experiencing either contraction or (best case) no growth whatsoever. The diverging growth stories in various major developed economies is leading to diverging monetary policies as well. Japan is intensifying its efforts to stimulate its economy, launching an aggressive form of asset purchases (quantitative easing) that is not limiting itself to government bonds. Europe is preparing to announce its next play in its fight to generate inflation. The Euro has declined well over 10% against the U.S. dollar in just a few months, and many project (present company included) that this depreciation doesn’t scratch the surface of what will eventually take place. With that said, a question exists as to whether or not there will actually be short-term divergence in these respective countries capital markets, or whether one nation’s sneeze will lead to another nation’s cold. Our highly globalized economy has simply not decoupled enough to allow for zero contagion effect. There is validity behind the narrative being described by most popular research on Wall Street that 2015 will be the year of divergence amongst global capital markets (vs. 2009-2014, where most markets really converged together). My expectation is for a final result of divergence, creating return opportunities in certain economies and markets. However, the shorter term result is, I suspect, likely to look much more like convergence (more so than pundits think), exacerbating short-term volatility.
The Ongoing Energy Saga
The fourth quarter of 2014 saw oil prices drop in excess of 40% from their mid-year highs, the majority of which took place just in the month of December. The trickle-down effect hammered stock prices of producers, drillers, refiners, and even (irrationally in most cases) the pipelines which carry the oil from the producers to the refiners. The cause of the sell-off is widely debated, but our thesis is that it has to do with geopolitical posturing by the world’s largest holder of oil reserves, Saudi Arabia. We do not expect them to bend immediately, but we do not expect this same production output to last through all of 2015 either. Regardless of the timing involved in oil prices going through a bottoming process, we do believe that many energy sub-sectors saw overdone responses to the drop in oil prices are due for a recovery. This includes the natural gas infrastructure space, the oil and gas pipelines (midstream), and even some of the oil services names. Should global demand truly show sustained levels of contraction (a forecast I am not willing to make at this time), the remedy to low oil prices will be – low oil prices (meaning, supply/demand factors will run their course before prices revert). Unknowns around the impact of all this what the impact of lower oil prices will be on the jobs market in the United States, and what the impact will be in the credit markets (where a lot of small and mid-cap energy names borrowed in the high yield bond market).
The Fed at the Head
I expect the greatest source of market volatility this year to be uncertainty about the direction of the Federal Reserve when it comes to their policy prescription for short-term interest rates. My general bias will continue to be expecting more dovishness than the consensus expectation calls for, meaning that I see rates rising by less than people think at a date which is later than people think. The issue will be how markets gyrate along the way as short-term prognosticators attempt to trade the Fed’s indications, etc. Fundamentally, I believe it is imperative that some normalization of monetary policy occur as soon as possible. I expect volatility leading up to and throughout the eventual decision to begin raising rates, and I also expect this to be a good thing (ultimately), not a bad thing. I intend to be prudent, patient, and cautious, but a short of a violent and sudden and totally unexpected hiking of interest rates I do not believe dramatic damage of the lasting kind will be done to the markets by Fed action in 2015. The key word there is “lasting”.
Risks to Keep in Your Radar
Global economic conditions could worsen in some countries to a point where the divergence thesis gets turned upside down. China’s economic slowdown is inevitable and well-known, but should their real estate and credit bubble face exogenous shocks it is not out of the question that a global contagion risk could surface. I see this as unlikely (that it would become epidemic), but it is a risk to watch and monitor.
Emerging markets are not likely to enjoy any tightening in the U.S. monetary policy, and they are not likely to enjoy the likely continued appreciation of the U.S. dollar. A focus on bottom-up company fundamentals will be key in emerging growth opportunities, as the macro environment possesses a lot of risks for that asset class.
Stock Markets in the Year Ahead
Investors should prepare themselves for the likelihood of rallies and sell-offs in the stock market throughout the year. Volatility levels have been depressed by a low interest rate environment and largely convergent global markets for quite some time. I expect 2015 to be positive in equity markets overall, perhaps even dramatically so (if euphoria surfaces and creates a blow-out multiple expansion), but not without significant volatility along the way. We will not be investing with a euphoric market blow-out in mind, but rather with a devout commitment to fundamentals and the principles we believe in: Primarily, investing for organic dividend growth as a primary objective rather than the speculative unknowns of P/E expansion. This strategy may prove to be somewhat defensive this year, and it also could result in an under-performance relative to overall stock markets (if the euphoria condition surfaces), but on a risk-adjusted basis we believe it is prudent and responsible, especially given the unknowns around monetary policy.
We would favor the U.S. stock market and even the emerging markets (with the caveat discussed previously) over both European and Japanese stock markets this year. We say that with the understanding that Europe is distressed now, and should conditions not worsen dramatically in their economy, it is entirely possible that their stock market will improve. Additionally, if Mario Draghi actually does match policy to his rhetoric and the European Central Bank goes on a quantitative easing binge, you may see some sort of European equity market rally that we would mostly miss out on. However, we think there are macro risks that are structural in their nature in Europe, and that the risk/reward proposition is simply not attractive. Tremendous uncertainty persists about the stability of their monetary union, they have no fiscal union to speak of, and organic growth is virtually non-existent. In Japan, the attempt to export deflation essentially through an all-out currency war may feel like the last stand they can take as policymakers, but it does not make me fundamentally attracted to their stock market. Even if currency were to be hedged I see demographic headwinds of an aging population and ongoing deflationary realities continuing to take their toll there.
We are invested in the Utilities sector but cautious there given the blow-out levels of performance most utility stocks enjoyed last year. We like much of the Industrials sector, and of course continue to believe in the pipeline story within Energy. Growth-of-dividend stock names exist in the Technology, Financials, and Consumer Staples sectors as well, and that underlying philosophy is just as important to us now as it has ever been.
Volatility and macroeconomic challenges along the way notwithstanding, we believe this present bull market will not be really over until P/E ratios reach 20 or more on the S&P 500. Market participants have not topped out in euphoria yet, but will at some point. I am more concerned with trying to limit market the effects of volatile gyrations on our client portfolios, but as far as big picture market movements go, this entire bull market has never been fully believed, and we favor the historical argument that the bull market will continue until that changes. When consensus goes fully bullish, we know it will be time to lay off our equity exposure. Until then, and based on our projection of a dozen or so 3%+ drops along the way, we are in a “buy the dips” frame of mind, especially as it pertains to dividend growers.
There is no question that the risk/reward proposition in bonds is troubling. On one hand, bonds will come in handy should certain really negative events take place in the macro-economy, particularly if stock market returns are suffering declines. On the other hand, if upside potential after last year’s rally in the long-dated section of the market is really muted you may be risking more than you want to for the potential benefit. The last several years has seen some bond investors attempt to skirt this issue by keeping duration low (limiting exposure to rising interest rates), but attempting to make up that lost return through greater credit risk. I have done this myself off and on for several years. My recommendations for 2015 include being more strategic in one’s bond allocations, staying underweight in total bond allocation but being tolerant of market movements along the way so long as a multiplicity of market outcomes are covered. I see us maintaining a fair amount of global bond exposure, as well as floating rate bank loan bonds here in the United States. Some degree of TIPS and intermediate core bonds may make sense as well, primarily for defensive purposes (not upside opportunity). What we do not want to do is take on equity level risk in the non-equity components of our portfolio.
Alternative Ways of Thinking about Alternatives
We remain a huge proponent of diversifying overall risk within a portfolio by incorporating alternative strategies in modest proportion to a stock/bond portfolio. We would not recommend doing this through direct commodity investment, which we have concluded offers uncompensated risk through an extended holding period. We remain cautiously optimistic about the REIT space (despite the sizable rally of 2014), but also recognize that interest rate movements are likely to hurt the price performance of many REIT’s on a short term basis. The major alternatives exposure we want to have is in one of two categories: (1) A calculated pursuit of alpha with a talented and non-correlated manager, or (2) A strategy designed to reduce portfolio volatility (preferably an opaque and understandable one). The significant negativity in the media about alternatives right now reinforces our belief in the asset class; it does not dampen it.
The chart below explains why we remain long-term believers in the merits of reinvested dividend growth. We view the job of the accumulation investor to compound his capital over time, and we know of no better way to do this than through a growing stream of dividends from high quality, well-managed companies. 2015 may create volatility around the energy markets, the Federal Reserve, and European contraction risk, but the principles by which we invest are time-tested and empirically defended.
The idea that investors ought to allocate across a wide spectrum of asset classes at all times and avoid chasing yesterday’s top performer has been reinforced time and time again. As you can see below, one year’s losers have a way becoming the next year’s winners (and vice versa).
Our outlook for 2015 is that the principles one should invest by in any year are the principles one should invest by this year as well. We do take a tactical viewpoint against Europe and Japan at this time, and we do have a slightly higher weighting to energy dividend stocks and emerging markets than some do, but tactical tilts notwithstanding, for an investor looking to generate a premium return over the risk-free rate – one looking to compound his or her capital over time – we believe a fully allocated portfolio will achieve this objective with less volatility over and over again. 2015 will not be an easy year for investors, but opportunities do exist for those looking. Our suspicion is that many of the boxes you see above which made the top of the list in 2014 will be somewhere else in 2014, and of course vice versa.