Download CWM Market Note: December 2014 If any doubt remained, 2014

CWM Market Note: December 2014
If any doubt remained, 2014 made it abundantly clear that the financial markets have been
supported by accommodative monetary policy over the past six years and if recent communications
by central bankers around the world are indicative of future policy, the markets should continue to
enjoy their support in 2015. Here in the U.S., the markets experienced several contractions during
the year most notably in October and then most recently in December. In each instance members of
the Federal Reserve intervened by offering a conciliatory tone and equities rallied to new highs.
As of this writing the Dow has breached the 18,000 mark and the major indexes here in the U.S. are
trading at or near their highs for the year. But it is not just stocks that have enjoyed an
accommodative Fed; treasuries as measured by the ten-year bond have generated strong gains for
the year as interest rates have remained at historically low levels.
Unfortunately, commodities led by oil, copper, and gold sold off, a sharp contrast to the gains for
stocks and bonds, as global demand was questioned. In addition, global stock markets that did not
enjoy the support of favorable monetary policy also lagged the U.S. markets on a relative basis. As we
close the year, the MSCI EAFE remains in negative territory down (4.41%) in dollar terms.
Market strategists had mixed results regarding their forecasts for 2014. Though generally correct
about the direction of equity prices, they completely missed on interest rates. The general consensus
was for the 10-Year US Treasury Yield to finish the year at 4% based on improving economic
conditions, but as the economy continued to vacillate the ten-year appears set to close the year in the
2.2% range, a far cry from 4%. The implication of this move was a rally in the bond market and
interest rate sensitive stocks such as utilities, areas the strategists had suggested avoiding.
Professional investors on average once again failed to beat the indexes supporting the drumbeat of
those favoring passive investing over active. In defense of active investors, the dispersion rate
among stocks was at all time lows given the over-arching impact of monetary policy over
fundamentals. Though this influence may continue into 2015, at some point active investors will have
the upper hand, but not until stocks are priced on such mundane metrics such as profits, growth
rates, and balance sheets.
On balance our portfolios performed well where a mix of indexes and individual equities more
heavily weighted to the domestic side provided strong performance relative to the markets.
Understanding that the allocation of assets would take precedence over stock selection, we employed
attributes of both passive and active investing preferring to focus on what would provide value
rather than adhering to a particular investment ideology.
However, as we close the books on 2014 our focus turns to 2015 and what the year may bring.
Though there are any number of issues that may impact the global economy and by extension the
capital markets, we will limit ourselves to what we believe may take precedence.
Monetary Policy:
Monetary policy whether directed by central banks or governments has been present in the financial
system for generations. However, the magnitude and dependence on monetary policy has rarely
been as dramatic and all encompassing as today. In an attempt to smooth or manage economic
cycles, we have created an artificial environment whereby the natural business cycle has been
disrupted and risk assets are no longer priced on supply and demand but rather liquidity.
The excessive use of monetary policy as a tool to manage outcomes is finite in both magnitude and
duration, but the longer it is attempted the greater the unintended consequences once it is
withdrawn or deemed ineffectual.
The efficacy of monetary policy continues to decline, but there are limited options available to central
bankers in their attempt to create a virtuous cycle of growth while combating deflationary pressures.
Though it is difficult to ascertain with any degree of accuracy how policy makers will act in the
coming year, our educated guess is as follows:
Europe is behind the curve in instituting a robust quantitative easing program preferring half
measures up until now. However, with most of Europe sliding back into recession and deflationary
pressures building we anticipate an attempt by the ECB to begin a program similar to ones enacted
by the Federal Reserve.
The Chinese economy, it appears, has failed to meet the government targeted growth rates and have
periodically instituted various policy programs to stimulate lending and growth. The effectiveness of
policy is unclear, but we believe they will continue this strategy as deemed necessary in the coming
year.
Japan is, to put it bluntly, a mess. For over twenty-five years the country has attempted through
various policy mechanizations to reverse the current trend with limited success and none that has
proved sustainable. The current policy termed “Abeconomics” takes the Keynesian model to its
logical conclusion; we can only hope that this time it will have better results.
The United States may be the focal point for monetary policy in the coming year. Having, some
would argue, stabilized the economy and provided a modicum of economic growth, albeit weak when
considering the effort, the Federal Reserve now finds itself in a difficult position.
If the Federal Reserve begins to normalize monetary policy by raising interest rates, they could cause
the fragile economic recovery to falter and slide back into recession. However, if the Fed does not
move to raise interest rates in the coming year they could lose the ability to react to the next
economic downturn when it occurs.
At present the Federal Reserve is forecasting inflation to range between 1% and 1.6% based on the
drop in energy prices and targeting GDP at 2.4%, an increase over previous forecasts. Over the past
several years the Federal Reserve has continually overestimated the rate of growth for the economy
causing us to be somewhat suspect of current projections and anticipate growth to actually come in
below forecast.
The highest probability in our opinion is for the Federal Reserve to tentatively raise rates in 2015 not
because of improving economic conditions, but rather due to the realization that risk assets are
artificially inflated and they have lost the ability (if indeed they ever had it) to be proactive in
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addressing a future crisis. Currently the Fed is calling for rates to begin increasing in 2015 with any
move being data dependent.
Unfortunately, the Federal Reserve should have begun to normalize policy much earlier in this
economic cycle and at this juncture it may prove to be too little too late. Having become dependent
on easy money, the markets may react poorly and similar to an addict going through withdrawal, the
process could be difficult with unintended consequences both here and abroad.
Discussion of the Capital Markets:
There is a natural tendency for investors to base investment decisions on the recent past assuming
that current trends will continue. If equities are rising it is assumed that they will continue to do so.
If a particular sector has outperformed or underperformed the assumption is at least for the
immediate term it will continue on the same trajectory. This investment behavior is one of the key
determinants that cause individual investors to underperform the markets as a whole.
As discussed, global monetary policy should remain accommodative or at a minimum neutral during
the first half of 2015 and if economic forecasts fail to meet current projections, it could extend in the
second half of the year. A continuation of current policy could support further gains for equities,
however as we have noted, volatility could increase as we near an inflection point.
Investors will be faced with a difficult conundrum as the year unfolds; do they continue to maintain
their allocation to equities or do they sell into further market strength? At present we would argue
for maintaining an appropriate level of stocks based on the individual’s objective and risk tolerance,
but to consider reducing risk as the year progresses. Though the trend for equities may be upward in
the first half of the year, we fully expect the magnitude of any subsequent correction to increase.
In a diversified portfolio we will normally suggest exposure to fixed income in order to provide
balance. However, as the interest rate cycle becomes extended, we are recommending for many of
our clients a transition to a laddered strategy via individual bonds. In doing so our objective would
be to provide a degree of certainty around both principal and income generation for our clients,
providing a measure of stability.
Though we believe the Federal Reserve will begin normalizing interest rates in 2015, global rates as
represented by the German Bund and Japan will effectively cap rates domestically as foreign
investors will continue the flow of funds into the U.S. where yields are significantly higher and
economic conditions more stable. If equities continue their upward trend we may leave some money
on the table, but the added stability in the bonds should be well worth any decrease in return.
Sometimes a contrarian approach can prove profitable…
In the past several weeks energy prices have sold off sharply based on excess supply and reduced
global demand. The sharp move down in oil prices blindsided most professional investors and the
assumption is that the downward trend will continue and in the short-term may in fact do so. The
question for a long-term investors is when will energy related stocks reflect attractive entry points
based on underlying fundamentals?
Europe is in a similar position as energy stocks. The Eurozone is mired in a recession, monetary
policy is dysfunctional, and there does not appear to be any catalysts to rectify the situation.
However, valuations are attractive and if the ECB can introduce a robust quantitative easing program
using sovereign debt, European stocks and bonds could outperform the U.S. on a relative basis in the
coming year.
Finally, everyone hates commodities and gold in particular. If an investor’s time horizon is six
months, avoiding gold is probably a safe bet. If your time horizon is five years there may come a
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point in time that gold rallies significantly, but whether it is gold, oil, or European equities, patience
may be the key ingredient needed to profit from these areas.
Final Thoughts:
The capital markets are still taking their cue from monetary policy and as long as policy is
accommodative and perceived as a net positive, risk assets will remain attractive. At present
fundamentals are a secondary concern and while not being completely ignored, have more impact on
individual names rather than the broad market. (And don’t be surprised if December’s rally stole a
bit from January.)
The bull market that was born during the financial crisis is getting long in the tooth and while
recessions, not time, usually end bull markets; this one may end by a change in a word by a central
banker from “patience” to “soon”. But for now the trend continues and we would argue for caution
and the understanding that we are closer to the end than the beginning, but the inflection point may
still be a year away.
Sincerely,
Brad L. J. Griswold
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investment, investment strategy, or product (including the investments and/or investment strategies
recommended or undertaken by Concannon Wealth Management, LLC), or any non-investment related content,
made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated
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