Economy: How are we doing?
The gap between a stronger U.S. economy and the weaker economies of other developed nations seemed to widen in the fourth quarter. In the U.S., job growth looked good as there were signs that lower gas prices were starting to spur consumer spending. In contrast, Europe's economy remained quite sluggish throughout the quarter, as fears of too low inflation and slow growth remained quite pronounced. Japan also struggled to find its footing, sliding back into a recession after a sales tax hike put a dent in consumer spending. Emerging markets, particularly China, also showed signs that growth was slowing down in the quarter.
The Federal Reserve ended its quantitative-easing program in October, as was broadly expected. Equity investors cheered the bank's statement that it would be "patient" before raising rates, reducing fears that the bank would raise rates early in 2015 against the backdrop of a strong U.S. economy. The Fed is still broadly expected to raise rates sometime in the year. The European Central Bank laid the ground work for easing programs to keep deflation at bay, and that bank seems poised to begin an asset purchase program sometime in early 2015.
Oil prices were in sharp focus during the fourth quarter. Crude started the quarter at more than $90 a barrel and ended at less than $53. This precipitous decline was driven by both concerns of oversupply in the market and weakening global demand. OPEC's decision to not cut supply accelerated the fall. Russia's economy was hit especially hard by the decline. Geopolitical concerns in the quarter, ranging from the continued conflict in the Middle East to Ebola worries in the U.S. and renewed worries over the stability of the Greek government and its impact on the Eurozone, created some waves in the quarter, but failed to deter the markets.
Broadly speaking, the recovery from the deepest downturn since the 1930s has been the weakest on record and it is still not clear how the global economy can break out of its current low-growth trap. There are several problems facing the global economy:
· With most consumers no longer willing, or necessarily able to take on more debt, spending is constrained by the growth in incomes
· There is a distinct lack of business-sector animal spirits
· Fiscal policy is still a headwind to growth as governments focus on reducing deficits
· Deflation remains a threat, especially in the euro area
· China has ended its rapid growth phase
The above points do not mean that the global economy cannot or will not grow, but the odds favor activity continuing at a disappointingly slow pace, rather than breaking out into a rapid phase that would signal a more normal expansion. For the next year or so the economic outlook is at best uninspiring, and this will ensure that inflation stays low and monetary policy stays accommodative.
2014: A Fractured Stock Market with increasingly narrow breadth
Looking back in history, the year following big up years in the stock market (such as 2013 was) tend to be choppy, fractured, and a tough year all-around. We saw this in 1994, 2000, 2004, and most recently in 2011 (1993, 1999, 2003, and 2009-2010 were robust years in the stock market).
However, this year the S&P 500 index defied expectations. After the U.S. stock market's double digit rise in 2013, it might have been safe to assume that stocks were going to take a bit of a breather this year – a correction was long overdue. Instead, the S&P 500 rose another 11% (albeit on weak breadth). On the bond side, most investors were expecting this to be the year in which Treasury rates began to rise. Instead, yields on the 10-year Treasury bond fell from 3% to 2.2%.
In a market with narrowing breadth sectors start losing strength (i.e. start declining) well before it shows up in the S&P 500 index. As individual sectors, one by one sell off, we are often left looking at the broad market indices as the last man standing. This is typically a time of “Buyer beware!” The weak breadth showed up in the broader stock market indices, as the stock market at large yielded uninspiring returns (e.g. the broadly diversified, non-cap weighted Value Line Geometric index was up only 2.69% in 2014).
Several sectors and asset classes peaked and began corrections in July. Typically, as a market moves closer to a more meaningful top, we often see sector drop outs and we were especially aware that this was happening in 2014. Small caps and high yield bonds are canaries for our domestic stock market and we saw clear and present danger signs there in 2014. Other warning signs emerged as well – the rising dollar (rising too far, too fast), a narrowing yield curve (narrow too much and it will invert = bad for economy) and net earnings revisions at a 2-year low (i.e. more down than up). We are hopeful, however, that small caps and high yield bonds can break out to new highs in 2015, effectively eliminating our concern but until then, our analysis cautions against “throwing caution to the wind.”The choppy markets of 2014 resulted in many of our client portfolios experiencing lower than historical returns. Nothing causes us more concern than lower than normal returns, but, as we look back over the past 20 years, we see that the time following a volatile period typically results in improved positive performance.
We know there is a large benefit to you of not chasing performance during fractured years in the stock and bond markets. That benefit is that those are the years of increased risk and the years in which the probability of a large decline increases. Essentially, those are the years that can change your retirement plans – permanently. At Zephyr Investment Management, we are conscious of what “the markets” are doing but really focused on giving you the highest probabilities of achieving your goals. Our objectives have both return and risk criteria. We know that it does matter the risk you take to generate your returns – and sometimes taking on the risk of the market is well rewarded, and sometimes (i.e. when breadth is narrowing) it is not.
2015: Looking Forward
We believe stocks are still your best, most liquid, bet for making returns in 2015. The bull market in stocks is still alive and fueled on improving fundamentals in the U.S. Additionally, the oil price drop is full-stop bullish for the U.S. economy on a 6-18 month horizon. True, valuations are not cheap anymore and clearly at some point in the future stocks will put in a longer term peak. They will do so in reference to hard evidence that the U.S. economy is beginning to decelerate, not because the Federal Reserve has become an enemy. We are now in the best six months of the year in terms of productive gains and in historically positive quarters of the four year presidential cycle.
We believe 2015 will display increased volatility in most domestic and international equity markets and we feel very confident that our tactical style will show the value Zephyr’s approach gives our clients. Our tactical approach attempts to protect against downside market action yet provides opportunities for participation in the upside. In 2015 we expect there will be continued uncertainty initially, which is a time for caution, but also typically a precursor to good investment times to come. This is when having a tactical manager like Zephyr is crucial to the health of your investment portfolio. 2014 has been the exception and not the norm for us, and such outliers have typically preceded stronger performance in the following months and years.
It shouldn’t be long now when the narrowing breadth of 2014 will resolve itself one way or another. Either the rest of the market will rise with the S&P 500 index, or the rest of the market will take the S&P 500 down along with it. If the U.S. economy continues to avoid recession, we would view any deep correction as a very rich opportunity to buy cheap stocks within a longer term global economic recovery. The U.S. is still the healthiest engine in the global economy so we should have the added support of international investors as well. We will plan to buy any significant discount in stocks in 2015.
While it’s been said “patience is a virtue”, when it comes to investing, it can mean the difference between a life well lived (with a disciplined approach) and going back to work in retirement (by joining the herd at the wrong time).
Let’s make it a great year!
The Zephyr Team
"We cannot direct the wind, but we can adjust the sails."