Jan 12, 2015
In the Books
A strong fourth quarter lifted U.S. stocks to record highs, generating the third consecutive year of double-digit returns. A familiar combination of solid corporate earnings, Federal Reserve stimulus and few attractive alternatives once again provided a good environment for stocks. Stocks also received support from the strongest back-to-back quarters of economic growth since the recovery began almost six years ago.
The fourth quarter, though, was not without its anxious moments. Sell-offs in October and December were sparked by renewed weakness in Europe, the Ebola scare, and the stunning drop in oil prices. But not unlike what we saw in the January pullback, each decline was followed by an equally robust recovery, quickly recouping losses and establishing new market highs.
Expecting “more of the same” has been sage advice for equity investors over the past couple years. Today there is more optimism around a potentially stronger economy. How that translates to the upside in stocks, however, is not always straightforward. We are mindful that sub-par economic performance these past five years has worked out fine for equity performance. With a stronger economy and other changes with respect to valuation and Fed policy, it is worth considering that this fourth longest bull market on record may actually give investors more of something else.
For the full year, the array of equity returns was more divergent between indices. The S&P 500 advanced 13.7% and the Dow Jones 30 gained 10.0%, while the Russell small stock index rose 4.9% and EAFE International Index declined 4.9%. Value and Growth styles performed similarly for the year. For the broad market, the defensive-oriented sectors of Health Care and Utilities performed best for the year while Energy and Telecom were the weakest.
The 45% plunge in oil prices over the past six months was not on the collective radar of investors. We believe the initial reaction from stocks was negative for two reasons – first, previous dips in oil prices have been associated with declining demand, meaning weakening global growth. Second, the 2008 Financial Crisis has sensitized markets to systemic risk – in this case, the fear that an oil shock could trigger a series of smaller unexpected events that could pressure the broader financial system.
Specific examples of this would be stress from financial institutions with loan portfolios too dependent on small oil producers, the impact on the high-yield bond market due to a concentration of energy-related junk bonds, a giant hedge fund that made a highly levered bet on higher oil prices now having to dump other assets to raise liquidity, or the broad economic and political implications of the collapse of the Russian ruble, due to Russia’s reliance on energy exports.
While there is a paranoid quality to ferret out all the things that could go wrong from something that on the surface looks like pretty good news, this is actually a healthy exercise. Until markets saw the ultimate impact of what a relatively small base of sub-prime mortgage debt could have on global finance, it was easier to not fully appreciate the danger of systemic risk. And unlike most risks that have been analyzed in advance, this freefall forced the market to figure this out in real time.
As the news was digested, a more balanced look took into account the supply side reasons for cheaper oil and the benefits to consumers at the gas pump and to businesses with reduced production costs for goods and services. Some analysts consider this a game changer and point to high oil prices as the primary constraint in keeping economic growth below capacity.
Saudi Arabia’s objective to regain the upper hand in controlling the price of oil is not hard to understand. Whether their primary target is West Texas and the Dakotas, Russia, or other OPEC members, they have the cost structure to let prices fall further and the time to wait it out – especially where hedging contracts still provide protection to big oil producers.
While ongoing energy projects are being curtailed and capital expenditures cut, this price decline may not be the crippling blow to our burgeoning oil production industry that it has been in past cycles. The potential for U.S. production to adjust to lower prices will largely be a function of further cost reductions in extracting oil from the ground. With the advance in horizontal drilling, fracking and other technologies, production costs of oil per barrel produced have been cut in half over the past three years and that trend is likely to continue.
Investment strategist, Don Luskin, has made an interesting geopolitical observation around high oil prices. His work tied last year’s high of $116 to the peak of the Islamic State (ISIS) scare. Out of this ultra-terrorist organization, Iran, Syria and the U.S. have found a common enemy and not so coincidentally, discussions have resumed with Iran around a nuclear weapons deal. Any form of détente between the U.S. and oil exporting nations can only diminish the premium that has been embedded in the price of oil for decades. When the Saudis have inflicted enough pain and decide they are ready to cut production to lift oil prices, there may be other key factors that could prevent oil from returning to the levels we’ve all taken for granted as the “normal” price of oil.
We understand that saying we wouldn’t be surprised by returns between -20% and +20% is not helpful. Nor do we attach much value to outlooks that express cautious optimism, but warn of higher volatility. Our read of today’s consensus view would include mid-to-high single-digit equity returns in 2015, inflation staying low, a Fed hike in early summer, slightly better economic growth, flattish bond returns, and bond yields moving moderately higher.
We also have heard cogent explanations on why equity returns will again be double-digit, how a return of wage pressures will resurrect inflationary concerns, why the Fed will err on the side of falling behind the curve and hold off on raising rates until 2016, why GDP growth goes back into its 2% or less shell, and why longer-term interest rates will actually decline when the Fed moves higher on the short end of the curve. These less probable outcomes are more interesting to talk about, but acting on them would imply some special insight in order to hold these beliefs with high conviction. That insight is not part of our process.
We will, however, offer the following related thoughts:
- The Fed’s first rate hike will be well telegraphed, but once the process has started, the uncertainty around subsequent moves will create more instability.
- Previous instances of optimism around a sustainable pick-up in U.S. growth have ended in disappointment. The rest of the world seems headed in the other direction.
- The strong dollar will depress exports, detracting from GDP growth. “King dollar” is a two-sided coin.
- The case for oil prices staying low for longer is compelling.
- National debt levels become a political and economic talking point again when the enormous cost of debt service rises with Fed hikes.
- Record IPO and Merger & Acquisition activity should continue as long as the bull market lasts.
- Greece will never go away as something some investors will worry about.
- 2008 showed stock valuations do not have to become stretched to suffer through a bear market, nor are all bear markets triggered by a recession; sometimes it can happen the other way around.
Lastly, after all this “top-down,” macro, thematic discussion, we restate our belief that “bottom-up” company-focused security selection is the highest quality source of excess return available to investors. This is where a firm like ours can add value – finding companies with unsustainably low valuations, not in handicapping what OPEC might do about oil prices (especially considering they probably don’t have a clue yet themselves).