2014 Review: For most of 2014, we believed the nearly six-year bull market had matured and equities offered a very poor risk-reward as unsustainably high profit margins and excessive valuation levels were poised to "regress to the mean." Because investors were not being adequately rewarded for taking equity risk, we believed they should decrease their equity risk exposure and increase their allocation to "safe assets" (government bonds, gold and alternatives).
Specifically, our investment thesis was that the excess liquidity created by the Federal Reserve's (Fed's) six-year Quantitative Easing (QE) bond-buying program -- coupled with excessive speculation and leverage -- caused financial assets to decouple from the sluggish economy, while driving equities to all-time highs and historic levels of overvaluation.
Additionally, we believed the market was vulnerable to a 15% decline in the fourth quarter as the Fed completed its QE program. Because the stock market, as represented by the Standard & Poor's 500 (S&P 500), had not had a 10% correction since October 2011 -- on average, the stock market has a 10% correction every six months -- we believed a correction was overdue and would be a critical litmus test for the global markets and economic stability.
In early October, European economic weakness and Ebola fears drove the market down 9.83% until October 16th, when St. Louis Fed President James Bullard, in our view, panicked and told investors that the Fed should extend QE. Bullard told Bloomberg News, "Inflation expectations are declining in the U.S. That's an important consideration for a central bank. And for that reason, I think a logical policy response at this juncture may be to delay the end of QE."
With the mere suggestion of extending QE, speculators knew the "Fed put" was intact and the stock market correction immediately ended. Over the following 30 trading days, stocks rallied 13.9% to record highs, although the Fed never did extend QE. While many investors and market pundits are pleased when the Fed and/or other central bankers jawbone the financial markets higher, we believe this interference with free markets and the price discovery process leads to excessive speculation, overleverage, a misallocation of capital and asset bubbles. In our view, free markets (not government and central bank intervention) are best poised to allocate capital, while an occasional correction attenuates speculative excesses, promotes the efficient allocation of capital, increases productivity and ultimately leads to higher living standards.
As previously discussed, we recommended that investors decrease (though not eliminate) their equity exposure and increase their allocation to safe assets (government bonds, gold, currencies) until equities offered a more favorable risk-reward. While the financial media and equity bulls chided conservative investors for "missing out" as they celebrated each marginal all-time high, we believe a cautious outlook was justified and that investors were not adequately rewarded for the level of equity risk they assumed. While equities outperformed safe assets on an absolute basis in 2014, given that stocks are more than four times riskier (based on volatility and historic drawdowns), safe assets were a sound investment, especially on a risk-reward basis.
|Risk Assets||Total Return |
|Safe Assets||Total Return |
|DJIA||12.7%||Long-term Gov. Bond (20+ year)||27.5%|
|S&P500||13.7%||Int.-term Gov. Bond (7-10 year)||9.0%|
|Russell 2000||4.9%||U.S. Aggregate Bonds||6.0%|
2015 Equity Market Outlook: We remain circumspect and believe that the Fed's six-year policy of inflating risk assets through financial repression (negative real rates, 0% interest rates, and QE bond-buying program) and jawboning has led to a historic misallocation of capital, numerous asset bubbles and an extremely poor risk-reward for equities.
We believe the market offers a very poor risk-reward and is poised to provide below-average prospective returns in the long run as profit margins and valuations regress to the mean. In addition to our core concerns -- stocks are historically expensive, investors are complacent and the Fed is no longer artificially supporting stocks -- the recent global slowdown (Japan, Europe, Russia, and China), the collapse in commodities (best exemplified by the drastic decrease in the price of petroleum) and the potential deflationary risk to the U.S. economy is troubling, especially because the Fed may be "out of bullets" as interest rates are already at 0%.
In our view, the nearly six-year-old bull market is mature, offers a poor risk-reward, and is vulnerable to a significant bear market (a decline of 30% or more). We believe the market's upside is limited (because of historically high valuation levels and unsustainable profit margins), and if the fundamentals regress to the mean, which is inevitable in the long run, the downside will be significant.
Stocks are 49% overvalued based on market value to GDP
Stocks are 55% overvalued based on dividend yield
Stocks are 36% overvalued based on cyclically adjusted earnings
Stocks are 16% overvalued based on Price to Sales
Stocks are 38% overvalued based on market value to replacement value (Tobin Q)
Profits at 10.45% of GDP are 2.5 standard deviations above its 65-year average of 6.46%
In the long term, we believe that valuations and profit margins are unsustainably high and, as the fundamentals regress to the mean, long-term investment returns will be disappointing. While we are confident that long-term investment returns will be below average, we are concerned that technical divergences and other market-based indicators suggest that investors are becoming more risk-averse, and that a correction is likely.
While the S&P 500 reached an all-time high on December 29th, the market's breadth has been weak for the past nine months, indicating that investors are becoming risk-averse. For example, the Russell 2000 small cap index has diverged and underperformed the S&P500 for the past nine months and remains below its March and June highs. Also, the majority of Nasdaq stocks are weak and below their 200-day moving average.
Small caps have underperformed large caps since March
Despite a recent 14-year high, 56% of Nasdaq stocks are below their 200-day moving average
In addition to the market's poor internals, many other assets and financial indicators (long bonds, junk bonds, credit spreads, real rates) indicate that investors' risk preferences have shifted, which often presages a significant market correction.
The 30-year government bond has outperformed equities for more than a year
The increase in real rates indicates that investors are demanding greater risk premiums
While the S&P500 reached an all-time high in December, high-yield bonds have been declining since September
High-yield bond spreads have widened over the past six months
While there appears to have been a flight to safety over the past six-to-nine months, many investors remain complacent. This complacency is probably because there has not been a 10% correction in over three years, which is the direct result of the Fed's aggressive QE bond buying program (which ended in October) and jawboning. While many pundits may believe low volatility and lack of normal corrections are a sign of market strength, we believe it is a significant warning that the excess liquidity, provided by the Fed, has artificially inflated asset prices and led to investor complacency.
Investors are ebullient, as there are the fewest bears since 1987
Economic View: After a weak first half of 2014, the economy was strong in the second half. While the strength in employment growth was solid (averaging over 200k jobs per month), wage growth remained disappointing and was only marginally above inflation. While many bulls have extrapolated the last six months of strength into 2015, we are concerned that weak real wages, excessive debt levels and global deflation will be significant head winds for the economy in 2015.
Our greater concern is that few of the structural issues -- too much debt, excess capacity, too little savings and aging demographics without a sound immigration policy -- from the "Great Recession" have been addressed. In fact, after six years of financial repression (ZIRP, negative real rates, QE), the Fed has only inflated asset prices and pushed our debt problems into the future. Since December 2008, our total debt has increased by $5.5 trillion, while our debt burden relative to GDP has only slightly improved from unprecedented levels.
There is more debt today than during the 2008 Financial Crisis
Total Debt to GDP remains at an unprecedented level
Since the Financial Crisis, we've believed that we've been in a global balance sheet recession, or a period of slow economic growth and balance sheet deleveraging. We are concerned that the Fed's use of "non-traditional measures" has not only delayed the deleveraging, but also encouraged more debt accumulation, especially by the Federal Government, by keeping interest rates artificially at 0% for six years.
Currently, there are significant signs of global weakness and deflation, especially in Europe, Japan and even China. These countries are now in the process of debasing their currencies to fight off deflation and grow their exports. Unfortunately, this currency debasement will export deflation to the U.S. by strengthening the dollar. Our highly levered economy will be vulnerable, especially because the Fed may be "out of bullets," due to its failure to normalize interest rates, despite our economic growth.
The Yen and the Euro are collapsing, which increases deflationary pressure on the U.S.
German and Japanese 10-year bond yields are in a race to 0%
We acknowledge that our deflationary view is very different from the consensus, which expects the recent economic strength to accelerate into 2015 and beyond. We believe reliable market-based indicators do not confirm that the recent economic strength is sustainable. In fact, the yield curve has been flattening for most of 2014, while inflation expectations have declined sharply since July, to their lowest level since the 2008 recession.
A flattening yield curve and falling interest rates are not consistent with an accelerating economy
In the past six years the Fed increased its balance sheet from 6% of GDP to more than 20%
Despite unprecedented balance sheet growth, inflation expectations are falling
Finally, many pundits believe that the recent crash in energy prices is good for the consumer and, therefore, a positive for the economy. We believe that consumers will use any energy savings not to consume more, but to pay down debt and increase their anemic savings. And because the energy sector has been a significant source of economic growth and job creation, we believe the crash in oil prices is another deflationary headwind for the economy.
We firmly believe that artificially low interest rates, set by the Fed, lead to a misallocation of capital, asset bubbles and, ultimately, a bust. The oil market is a good example of the problem with the Fed's aggressive monetary policy. The Fed created a negative interest rate environment with the goal of pushing savers out on the risk curve, inflating productive asset values and creating a wealth effect to stimulate aggregate demand. Unfortunately, in periods of negative real interest rates, many investors seek the safety of hard assets, such as gold, oil, real estate, and commodities, as an inflation hedge. So, while the Fed wants the excess liquidity they create to go into productive assets, it also artificially inflates hard assets. This price increase gives a false signal to the market that there is excess demand, so corporations and entrepreneurs build capacity to meet the increased demand.
We believe QE inflated oil (and most other assets) to an artificially high price and also led to low financing costs, which justified the massive capacity expansion in the oil market. While the catalyst for falling prices may have been weakness in Europe and OPEC's shift from managing price to managing market share, once the bubble burst, the misallocation of capital and excess capacity became apparent and a panic ensued.
The oil market may be the first of many asset bubbles that will burst now that the Fed is not pumping $85 billion a month ($1.05 trillion per year) into the financial markets.
Oil has crashed 57% over the past seven months
The bear market in commodities is a sign of weak global demand and excess capacity
In conclusion: The current bull market is one of the longest on record, in both magnitude and duration. Over the past five years and nine months, the stock market has appreciated 214% and compounded at 21.9% per year versus the long-term historic average of 10%. Also, the market has not had a 10% correction in 3.25 years. We believe the strong bull market, coupled with the lack of normal volatility, has led most investors to become complacent, and many to become excessively speculative.
We believe the technical deterioration over the past nine months, coupled with the decreased level of liquidity in the market (due to the end of QE), will lead to a significant correction. Whether or not this correction becomes a bear market (30% or more) will depend on how our economy adapts to declining asset prices and the increased threat of deflation.
As value investors, our core philosophy is that the best way to grow wealth is to have a long-term investment horizon and avoid major losses. Because profitability levels and growth regress to the mean over time, valuation is the best measure of long-run prospective returns. Currently, the equity markets are overvalued and offer a very poor risk-reward. We believe investors should reduce their exposure to risky assets and be patient until the risk-reward improves. Historically, liquidity-driven bull markets deflate quickly and patient investors will then be rewarded with great values and significant long-term opportunities.
Our current asset allocation is defensive, our risk allocation is balanced and we are focused on capital preservation:
|Large Cap Equity||30.0%||Long-term Gov. Bonds||15.0%|
|Small Cap Equity||(10.0%)||Int.-term Gov. Bonds||10.0%|
|International Equity||0.0%||Municipal Bonds||15.0%|
|Emerging Markets||0.0%||U.S. Aggregate Bonds||0.0%|
|High Yield Debt||(10.0%)|
|Gross Risk Assets||40.0%||Gross Safe Assets||58.0%|
|Net Risk Assets||20.0%||Net Safe Assets||38.0%|