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Quarterly Newsletter – Winter 2015
“It’s Déjà Vu All Over Again”
Yogi Berra is a Hall of Fame baseball player known as one of the greatest catchers of all time, yet he may be equally famous for his comically confusing quotes colloquially known as “Yogisms”. In attempting to convey our views on this confusing market environment, we think a few choice Yogisms are in order. We’ll make occasional references to our summer 2014 newsletter and suggest reading it if you have not already done so as it helps give a background on our thought process.
“I didn’t really say everything I said”
The beginning of the year is always a good time to review the things you got right and the things you got wrong in the previous year. In the summer, our 6-12 month outlook for the market was a potential upside of 5-7% with a downside of 10-20%. We pretty much nailed that on both ends as we did have a 9.8% correction during the fall and the S&P 500 is up 6% in the six months since our summer forecast. We were off in how the correction played out though, and it consequently affects our outlook for 2015. We thought the market was due for a slightly more significant decline than it ultimately experienced. We correctly suspected that any correction would be a buying opportunity, but we thought the rebound back to new highs would take much longer than it did. The S&P 500 bottomed out on October 15 and fully recovered to a new high on December 29. We anticipated this rebound would take 3-6 months, not the rapid 6 weeks as proved to be the case. The result is that we need to upgrade our forecast for the market to account for this unanticipated strength.
We dedicated just a mere paragraph to the crude decline back in the summer as prices had just started moving from the June peak. We certainly did not anticipate a decline in Brent crude from $114 in June 2014 to a 6-year low of $45 in January this year. This whopping 60% decline in a span of less than a year has significant implications for the markets in 2015, as we’ll discuss later.
“A nickel ain’t worth a dime anymore”
We found it humorous when certain Fed members were discussing inflation fears at one point last year. We consider deflation to be far worse than inflation because of its negative affect on consumption and because of the large amount of global debt. Deflation affects consumption because consumers delay making purchases if prices are perceived to decline in the near future. This in turn can reduce economic output, impact wages, and lead to further price declines that result in a deflationary spiral. This would generally lead to a decline in tax revenue, making debt servicing more difficult as interest rates on most debt are generally fixed.
Deflation is very much a concern for us as we consider global risks in 2015. In the U.S., the Consumer Price Index (CPI) is down to 0.8% and trending lower. Low economic output, stagnant wages, low commodity prices (lead by crude), and a stronger U.S. dollar are all contributing factors leading to the current disinflationary environment. The situation is worse in the European Union as their CPI slipped into negative territory at -0.1%.
The deflationary concerns in Europe affect us in the U.S. because their central banks need to keep an accommodative policy that is at odds with our attempt to return to more normalized interest rates following the October end of quantitative easing. This results in relatively higher interest rates in the U.S. which leads to investment flows into the U.S., resulting in a stronger dollar. The stronger U.S. dollar has broad implications for investing in 2015.
“Nobody goes there anymore. It’s too crowded”
The most crowded trade of 2014 was probably the strong dollar. While it makes us uncomfortable to be part of the crowd, sometimes there is a good reason for a crowd. The drivers for a stronger dollar in 2014 were, better relative economic growth, lower relative risk, and higher relative interest rates. We do not see these factors changing in 2015.
A strong dollar impacts large multinational companies more than smaller companies. This is a result of the geographic distribution of revenue. Large companies depend on a larger portion of international sales than smaller companies. This typically favors small cap stocks over large cap and was likely a factor in small cap strength in the 4th quarter last year.
The strong dollar may continue to be a headwind for commodities in 2015, despite the recent rebound in crude prices. Our tactical asset allocation and stock selection process continues to favor investments that are more insulated from a strong U.S. dollar. However, we don’t expect the dollar appreciation to be a straight line and expect some volatility in currencies throughout the year. We believe that the impact of foreign currencies on investments should receive proper consideration from an asset class, sector, industry, and individual security basis in 2015.
“When you come to a fork in the road, take it”
Investing comes down to two main choices for many investors, stocks or bonds. Bond yields are still well below historical norms and insufficient for many investors to meet their return needs. The yield on a 10-year treasury, for example, is currently at 1.99% and had been as low as 1.67% on February 2nd. It may seem that Punxsutawney Phil facilitated a warming of wintery interest rates when he awakened from his burrow, but we believe that the strong dollar, attractive interest rates from a global perspective, weak economic output, and low commodity prices will cast a shadow on interest rates well into 2015.
Both metaphorical forks led to many different places as asset class returns were quite mixed for 2014. This created an opportunity for firms using a tactical asset allocation approach to potentially create more value for their clients compared to firms that only use a strategic asset allocation method.
Asset Class Returns for 2014 S&P 500 Sector Returns for 2014
Real Estate Investment Trust (REIT) 30.4% Utilities 24.29%
Standard & Poors 500 (S&P 500) 13.69% Health Care 23.30%
Russell 1000 (Large Cap) 13.24% Technology 18.18%
Russell 3000 (Multi Cap) 12.56% Financials 13.10%
Russell 2000 (Small Cap) 4.89% Consumer Staples 12.87%
Emerging Market Equity -2.2% Consumer Discretionary 8.05%
ACWI – US (Foreign Equity) -3.87% Industrials 7.52%
EAFE (Foreign Developed) -4.90% Materials 4.68%
S&P GSCI (Commodities) -33.87% Telecom -1.91%
Barclays Aggregate (Taxable Bond) 5 .97%
Inflation Protected (TIPS) 3.7%
High Yield Bond 2.1%
Emerging Market Bond -3.9%
“It ain’t over ‘till it’s over”
The October almost correction of 9.8% failed to reach the official 10% level to be considered a technical correction. Consequently, we’ve now gone 1,228 days since the last correction in October 2011. That’s much longer than the usual correction every 347 days that we’ve averaged since 1945. We might be in the later innings of this game, but as Yogi said…
The market trend is fairly strong right now. The S&P is very near the December 29th peak at 2,090. There has been some early volatility in the market already this year, but the market has shown resiliency with buying interest around the 2,000 level on the S&P 500. Buying on dips in the market has been a successful technique since the last full correction over 3 years ago. This has essentially put a floor under the market as it seems investors fully expect that trend to continue.
Investor sentiment is slightly elevated above the long-term average as measured by the American Association of Individual Investors. Inflation remains very low and we think that it is unlikely the Fed will raise interest rates at all in 2015 given the disinflationary fears and the accommodative positioning by their European counterparts. This should continue to induce risk seeking behavior from investors seeking returns greater than can be achieved with bonds. This bodes well for a continuation of this lengthy rally in stocks.
Valuation continues to be a concern for us. The S&P 500 is trading about above its fair value based on its historical mean price to earnings (P/E) ratio. Some premium is to be expected considering the low inflationary environment, but we do not think corporate earnings are going to grow sufficiently to justify the current multiple. Ultimately, we believe that a correction is necessary to bring the market back in line with a more reasonable valuation.
“It’s déjà vu all over again”
This year looks a lot to us like 2014. In fact, the performance is following a similar pattern. The S&P 500 declined 3.46% in January 2014 and was down 3.00% in January 2015. February 2014 showed an increase in the S&P 500 of 4.57%, much like the month to date increase of 3.35% for February this year.
We believe there is more macroeconomic uncertainty this year than last year. The large decline in the price of crude oil has materially impacted several nations, like Russia, for which energy is a key part of their economy. The European Union looks less stable to us than last year and that it ultimately cannot continue in its current form. The imminent departure of Greece is unlikely, but further progress to that end may be more apparent this year.
We think the October almost correction helped clear out some of the complacency in the market. While we saw the markets skewed to the downside before the correction, we see things more balanced now. We think the S&P 500 has roughly an upside potential of around 12% for 2015 with an equal chance for an approximate 12% correction sometime during the year. The range of potential outcomes is much wider than +/- 12%, so this is merely our crude estimation of what we think is likely with the information we have today.
“You can observe a lot by watching”
We think 2015 is a difficult year to try to forecast. We’ve done our best to prepare for the year and position client investments accordingly. It’s a year in which we are keeping a watchful eye on many different areas of the global economy and markets.
Energy will be a key area to observe. We’re not completely sold on the early rebound in crude oil as we are unsure that the supply/demand imbalance has been neutralized, but we are cognizant that there may be some investing opportunities in this sector. We do think energy prices will stabilize at some point this year, but this it’s premature to say that the rebound will be sustained.
The increase in discretionary income from the decline in fuel prices has not yet appeared to benefit the consumer sector. We think that benefit will be more evident later in the year, and we have been investing in companies that we think will prosper from an increase in consumer discretionary spending. We’ll be watching for additional opportunities within the consumer sector this year.
Political shifts can have a material impact on investments. We believe the healthcare sector has benefitted significantly by the Affordable Care Act overall with some industries more directly affected. We’re watching to see what changes may affect this program now that the Republicans have gained control of the Senate. We don’t see anything of consequence on the immediate horizon, so we think the gains in the healthcare sector can be maintained. The managed care providers in particular should be able to keep their momentum going in 2015.
“If you don’t know where you are going, you will wind up somewhere else”
We believe that it’s important to maintain a long-term approach to investing while giving proper consideration to short-term market fluctuations. We have a specific long-term plan for each of our clients, but we make tactical shifts where we see opportunities and risks. We make forecasts that are more specific than most firms are willing put in writing and we do so at the risk of being wildly incorrect. However, we think investors should be privy to our thoughts even though the nature of the market is such that the short-term is largely unknowable.
We think investors will continue to buy dips as they occur. We think buying on dips toward a predetermined investment plan is a prudent way for investors to use excess cash. We think that maintaining an elevated level of cash for tactical deployment makes sense in this environment. While 2014 was a decent year for bond returns, we do not see that repeating in 2015 as there is likely less chance for appreciation of bonds.
We think that, while the market may trade in a similar fashion to 2014, it may do so in a more volatile manner. Investors should assess their portfolios to ensure that their investments are structured consistent with their risk tolerance. The length of the market rally from 2009 has likely resulted in many investors having an equity allocation that exceeds their specific loss tolerance. The large variance in asset class returns in 2014 has likely also created unintended skews from their target allocations. Some degree of rebalancing should be executed even with the goal of maintaining specific tactical shifts.
All investment decisions should be based on your specific situation. Please speak with your financial advisor before considering any changes to your investment portfolio. The information we have provided is for informational purposes only and is not intended to represent specific advice to anyone. We are not guaranteeing the accuracy of any information contained in this report and will not be held responsible for any errors or damages that result from acting on information in this document. Any item from this document may not be copied, quoted, or redistributed without written permission.
This information is published for residents of the United States only. Investment Advisor Representatives may only conduct business with residents of the states and jurisdictions in which they are properly registered. Therefore, a response to a request for information may be delayed until appropriate registration is obtained or exemption from registration is determined. For additional information, please contact Jason Self at info@RezFin.com or 512-520-5966
Resonance Financial is a comprehensive wealth management firm offering financial planning and asset management in Austin, Texas. Investment advisory services offered through Resonance Financial, LLC a registered investment adviser.
Jason Self, CFA, CFP®
6500 River Place Blvd
Building 7, Suite 250
Austin, TX 7873