Year End 2014

………………Thoughts and Comments


2014 was such a great year! The stock markets were up! The bond markets were up! Oil prices are down! And 2015 is expected to be an even better year, according to the Wall Street pundits!

We figured that we would wait to publish this 2014 review until after Jan 1 so that you could recover from your holiday and investment celebration hangover all at once.

Results for the Year:

S&P 500                       Up 11.39% with GDP up 1.8% for the three quarters of the year.

Japan                           Up 7.12% with Japan having slid into a recession during the second and third quarter of the year and is down 0.77% for the year (3 quarters reported only).

DAX (Germany)           Up 2.27% with GDP up 0.74% for the first three quarters of the year.

Shanghai (China)         Up 50% with China’s economy slowing by over 30% this year to about 7%.

CAC 40 (France)          Down 0.54% with GDP up 0.15% for the first three quarters of the year.

FTSE (UK)                     Down 2.71% with GDP up 2.17% for the first three quarters of the year.


Where, Oh Where, has all the Investment Sense Gone?

Given these results, and given that markets are supposed to be discounting mechanisms, the data above suggests that expectations are for strong growth in the U.S., China, and Japan this year, while expectations for Europe and the emerging markets are very modest.

But does this make much sense? Looking at U.S. economic factors, it is hard to get too bullish:

1) Oil

How will falling oil prices will affect the economy? Oil prices have dropped substantially in the past three months: as of this writing, light sweet crude dropped to under $50 a barrel – the lowest we have seen since the 2008 crash. Oil prices are down because supply is rising while demand is falling. Falling demand for energy is not typically a growth sign for economies. Oil companies have started to significantly cut capex plans for 2015, which would be a drag to GDP. In addition, we have started to see the impact from companies that do business with oil companies. For example, U.S. Steel just announced over 600 layoffs due to the idling of a plant that makes pipes for the oil industry.

About 16% of U.S. junk debt is related to oil drilling. If oil prices stay down long enough, there are likely to be some defaults, a risk for U.S. banks, especially for some of the larger regional banks who were especially aggressive with this lending. However, given that many of the banks also use credit default swaps, we don’t really know who is exposed to the risk.

Most of the high-paying jobs that have been created since 2008 are in the oil patch, so there is the potential for a negative impact if and when layoffs start happening in force.

On the positive side, lower oil prices can have a positive economic impact, as the cost of many goods is affected by the price of oil. From chemicals (and many types of manufacturing) to the cost of shipping, oil touches businesses, and therefore consumers, in numerous ways. If businesses pass on gross margin improvements to consumers, lower prices could help control some inflationary pressures that families have been battling.

Lower gasoline prices potentially can lead to increased spending as well, if consumers feel more optimistic about their economic situation. While savings in oil aren’t the sole ingredient for this, it certainly can have an impact.

2) Capex Spending and Corporate Debt

Companies were predicted to expand their capex spending in 2014, but once again that did not happen (this was also predicted in 2013). However companies have spent a near record $550 billion to buy back stock, leaving debt levels the highest they have been in a decade. IBM, Oracle, and McDonald’s are examples of companies that have reported declining or flat sales for many quarters and yet had continued to take on debt.

Data provided by S&P Capital IQ


3) Wages

Wages for most employees have stagnated, even with the increase in the minimum wage in twenty states. At the same time, however, healthcare costs, food costs, housing and rental costs have all risen by more than 20%, according to a six year study recently published by the Bureau of Labor Statistics.

However, there are hints of employment expanding, which ordinarily brings higher wages. This is something that will have to be watched. Increased wages would lower corporate profit margins but could increase revenues and earnings as people have more money to spend on discretionary items.

4) The strong dollar and the economy

The dollar is at an 11-year high versus other major currencies. With some 14% of the S&P 500 affected by the value of the dollar, this should start to have an impact on sales and earnings in the Q4 of 2014.

Again, however, there is an upside. While a strong dollar can be a headwind for companies, it can be a wonderful benefit to consumers who suddenly find their money buys more. Remember all the foreign travelers we had seen for a number of years in the 2000s? Now Americans will find that they can afford to travel more and spend more.

The U.S. economy is not terrible, even if it is somewhat anemic. As mentioned earlier, employment is picking up and wages may be, as well. Housing, while not as strong as the prior year, is still doing fine – again nothing extreme, but chugging along at a reasonable rate. If the rest of the world does not continue to weaken further, our economy will do fairly well.

Data provided by S&P Capital IQ


5) Stock market: Fundamentals and reality

This is the one area where we struggle to find positive arguments. Stock valuations are high based on any historic metric one wants to use (Price to Sales, Market Cap to GDP, and Price to Earnings are all at or near highs).

Data provided by S&P Capital IQ


Data provided by S&P Capital IQ


Even with a positive outlook for the economy, it is hard to justify expanding multiples further. If wages increase meaningfully, which would increase revenues and net income for companies (on the assumption that consumption would increase), with stock prices so high, it is hard to see much price appreciation.

The Fed, which has created the market we have been in by printing money for the better part of the past six years (except for short periods of time in 2010 and 2011 which led to stock market corrections), should get much of the credit for this “bull” market.

However, the fact that it is a bull market based on massive money printing (effectively manipulation) means that it is a house of cards. We would note two things. First, such manipulation has left the markets without their normal self-correcting mechanism to remove excesses. The stock markets have not had a 10% correction since October 2011 – 3.25 years. Typically, the markets have experienced a correction every 12 to 18 months. Second, the amount of stocks purchased using margin is above 2007 levels, and near an all-time high – such leverage does not typically end quietly, as 2000 and 2008 remind us.

Also, we would note that in the past several weeks, this same Fed has slowed the presses. It will be interesting to see if once again, stock prices decline when the Fed is not printing as fast as they can.

While the Fed raising short interest rates will be good in the long run, the prospect brings up many questions.

First, will they raise rates? The bond markets are saying it will happen much slower and take longer than what the Fed is indicating. If the markets are wrong, this will lead to bigger, faster losses in the bond market, something the Fed doesn’t want to see happen.

Second, raising interest rates will have a dramatic impact on the federal government’s interest payments on their debt. With a record 6 trillion dollars in debt, which has grown exponentially in the past six years, such an increase in debt payments will put a significant strain on our ability to pay our debts.

This is of course, unless the Fed comes up with a new form of QE. Now on the one hand, the Fed is looking to the rest of the world to start QE’ing like we have. The ECB is talking about it on the 22 of January, Japan is talking about it as well and so is China.

On the other hand, the Fed might raise short term rates but then come up with some bond or stock buying program to offset this. All of this, could potentially push stock prices up higher based on the “where else is there to invest?” argument.

Certainly, either way, the Fed will, until they get out of the manipulation game, cause uncertainty and therefore volatility to the investment markets.

If the U.S. Is the safe haven, what of the rest of the world?

When we look at the rest of the world, things don’t look much better. Europe is still struggling with their bank debt. The ECB is threatening to print money, just like the U.S. has, and that has buoyed stocks and treasuries here in the U.S. However, to date this is still just a threat as Germany has been resisting.

1) Defaulting countries back in the news

Greece is back in the news: funny, this was where the EU was three years ago! Greece once again is potentially going to drop out of the EU. What does this say for Spain and Italy, which have made no headway in the past three years either?

2) Oil

Oil prices, as previously discussed, have been declining because demand has been falling around the world. Saudi Arabia has refused to reduce supplies so as to maintain market share (and so has Russia), and this is having an impact on numerous countries:


  1. Emerging markets. Russia, Venezuela, Mexico, and Brazil all are feeling pressure because oil export is a significant portion of their economies. Many of these countries were already under pressure due to slowing economies around the world;
  2. Junk debt. Oil is Russia’s primary source of hard currency, and with the added economic sanctions, the country’s debt is rapidly becoming of questionable value. Most Russian debt is held by European banks and China, although given the use of swaps, we would not be surprised to find that U.S. investors have risk exposure they do not know about;
  3. Developed Markets. Oil also is a source of income in Europe (Norway, Denmark, Germany and France, Italy, Netherlands and Spain), the U.K., Canada, and Singapore, which means many of our trading partners’ economies are feeling additional pressure.

3) Global Interest Rates and Stimulus:

Current 10-yr government rates

US:       2.03%

EU:       0.47%

Japan: 0.28%

UK:       1.67%

Switzerland has just announced it will lower its short term rates to -0.25% (yes, you pay them to hold Swiss debt) in order to keep everyone in Europe from buying their currency as a safe haven vs. Russia, as well as to help keep their exports going because Switzerland’s GDP is dependent upon exporting goods to the rest of Europe.

Of course, everyone else is playing the same game, so it is a race to the bottom. China just announced they are lowering interest rates in order to stimulate their economy. The problem is that their economy is driven by government spending, not household spending. Debt to GDP is estimated at ~250% in China. Housing prices have been dropping for 7 months and individuals who were speculating in housing are now speculating (with leverage) in their stock markets.

Japan has not successfully stimulated their economy, even with all of the fanfare about Abeonomics (the U.S. money-printing strategy translated to Japan). In fact, the country has fallen back into a recession in the past six months.

4) Russia

With the Ruble collapsing due to the West’s sanctions, combined with oil prices, Russia is a serious investment risk if the western countries don’t back down on their sanctions. Equally important, Russia’s internal problems probably lead to continued Cold War-era conflicts (remember the Ukraine?)

5) The Middle East

While largely invisible from the pages of newspapers, this region still has a number of wars going on. The instability there has the potential to lead to instability around the world. We have seen it in Australia and now, unfortunately in France. This is the kind of “Black Swan” event that could scare the markets.

Usually One Should Zig When Others Zag – But What if Everyone is Doing Both?

It seems to us that several things are going on at the same time, which explains the strength in the U.S. stock markets.

First, investors have forgotten what risk is and what it means to an investor. Many have fallen back into the habit of interpreting risk as meaning that you are sure to get a higher return, rather than understanding that your risk is the expectation that things could go wrong and that you actually could lose. The high risk requires high returns to compensate for the chance that one might lose more than an “average” amount. The fact that investors in the U.S. have been putting record amounts into index funds in the U.S., and again we are near record levels of margin debt, reflect this misunderstanding. Why wouldn’t you invest this way when stocks only go up and only suckers or fools aren’t fully invested in stocks?

This is not just happening in the U.S., either. In China, housing speculation went on for years, and now that prices have dropped so dramatically, many Chinese investors have turned to stock market speculation and again, are using leverage to play.

Second, governments around the world are perpetuating the idea that there should never be pain, and if we would just give them limitless power, they will make all of our lives perfect. Thus, they push the idea of printing money as a way of solving problems so that no one ever loses – except this is nothing more than a Ponzi scheme which finally collapses on itself.

Federal reserves around the world are all printing money as fast as they can, in hope that they can devaluate their problems away. There has never been a single time in history when this has worked, and the citizenry ends up paying the bill with declines in their standards of living – significant declines.

Third, the markets are no longer discounting mechanisms because of the immense leverage that the global federal reserves have pumped into the system. This manipulation keep markets from working rationally, leading to wild moves that no longer correlate to economic facts. This, of course, circles around to our first revelation about risk.

Add to this that cheap money adds to speculators using leverage and trading in anything that moves, rather than investing in long-term businesses. Stocks are no longer representations of a company and the value that company creates through its business, but rather a simple commodity that are to be traded based on the momentum of the moment.

Strategy for 2015:

We believe that we continue to walk a tightrope. There are various headwinds, tailwinds, and crosswinds that make traversal risky. However, in our scenario, the building you start at is on fire, so doing absolutely nothing does not guarantee your safety either.

So what to do? First, we believe that there some opportunities that could be quite interesting over the long term. India is an example of an area where, while they have their own problems, leadership is making some substantial changes to the way they do business, which over time, could be very beneficial.

The same is true in Mexico, but currently the oil markets are a real pressure on them. Once oil stabilizes, Mexico will become more attractive as we believe the loss of income from that industry will encourage the country to continue to restructure its economy, as they have been working on for several years.

Oil will stabilize. It is a cyclical industry and these kinds of swings are very important to balancing supply and demand. Once we have seen some real pain, there will be some very attractive opportunities, and we are already analyzing what to buy when the timing is right.

For instance, we have already been purchasing energy debt – investment grade and shorter maturities. This approach reduces the risk of any default and any interest rate risk, while getting returns that are factors higher than what can typically be earned in high quality short-term corporate debt.

Diversification is going to continue to be important, and focus on valuations will be pivotal.

There are articles in the Wall Street Journal already which speculate that money managers are jumping on stocks at each sell off because they are fearful of missing any upswing, following weak performance in the past several years.

We believe that there are two strategies for managing money: 1) make the highest returns possible and let clients be responsible for allocating their capital and being responsible for controlling the risk of the investments; and 2) provide risk management for client portfolios, where the manager is more concerned about the clients’ long term financial health, rather than keeping up with the markets, regardless of the risk.

Either strategy is very reasonable, as long as clients understands the manager’s strategy and accept it.

The Bottom Line…

We have been worried about risks in the stock market for some time. Fundamentals simply do not support stock prices at such a high level, especially given the numerous risks that we have discussed.

What one has to remember is that the stock market and the economy have disconnected – something that happens from time to time when investors become too complacent. Could the market continue to rise?  Certainly – but the question is not whether the stock market will go up, but whether investors are taking overly large or small risks for the potential returns.

Thus, we again argue that now is not the time to be 100% in stocks and that one must be careful when choosing what exposure to have. We continue to like special situations, such as the play on energy bonds. Later, once things have washed out more fully, we will do the same in energy stocks – but not just yet.

In the meantime, some exposure to India may become worthwhile and again, once oil has stabilized, so could Mexico.

Equities that are primarily focused on U.S. domestic markets and which may have parts made abroad, so that the strong dollar is advantageous, will also be places to look.

At the same time, though, investors must expect increased volatility (as we have seen from the first week of 2015) and lots of whipsawing, as leverage is still a big player. Set a plan that allows you to be comfortable with the volatility (i.e., don’t get overexposed to a sector or asset class) and follow the plan. Take advantage of other investors’ fears, but don’t panic yourself. Most importantly, don’t get greedy – and be patient.

Alan E. Rosenfield, Managing Director

January 2015


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