Download CFA Outlook 4Q15

Investment Outlook
Fourth Quarter 2015
October 1, 2015
By
John E. Montgomery
Managing Director & Chief Investment Officer
Capital Fiduciary Advisors, LLC
4720 Montgomery Lane, Suite 400
Bethesda, MD 20814
301-652-6951 (phone)
301-652-6954 (fax)
[email protected]
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It’s not nice to fool Mother Nature!
Fellow oldsters will recognize the tagline from the Chiffon margarine ads of the 1970s
and early 1980s. When tricked into confusing Chiffon margarine for “my delicious
butter,” Mother Nature (played by actress Dena Dietrich), accompanied by a bolt of
lightning and a clap of thunder, bellows out “It’s not nice to fool Mother Nature!”
There are still a handful of us who believe in free market capitalism and feel that
in spite of the best efforts of many to circumvent it, free markets continue to deliver the
goods. Ironically, the Federal Reserve has been trying for quite some time to trick the
economy into growing faster than it probably can with its easy money policies of ZIRP
(zero interest rate policies) and QE (quantitative easing). Theoretically, this is
accomplished by lowering the risk-free rate of return to such a level that people—we are
reluctant to call them investors—are forced to buy riskier assets in order to get higher
returns. Lowering the rate in this way should, in turn, raise the price of bonds, stocks, and
real estate, triggering a “wealth effect,” which in turn stimulates economic growth.
Hmmmm! Instead, these efforts have been making rich people richer without really
causing the economy to grow faster.
Now, every time that the Fed seriously considers ending this experiment, the
markets pitch a fit causing the Fed to back off. So, to its dual mandate of stimulating
economic growth with low inflation and seeking full employment, the Fed has added
keeping the financial markets happy, especially the stock market, along with making sure
the dollar doesn’t get too strong and emerging markets don’t get too riled, and labor
receives higher levels of income growth while also promoting economic equality, and
anything else that comes to mind. All this can be accomplished by maintaining low shortterm interest rates. WOW!
Besides making the rich richer, the Fed has inadvertently increased investor angst,
caused economic uncertainty, and created a political atmosphere of envy. This has helped
the far right and the lunatic left and upped the political aspirations of Donald Trump and
Bernie Sanders. Both seem to appeal to those who would like to see smaller government,
but only a smaller government that will give us more free stuff while coming up with
simplistic solutions to complex issues. If The Donald and The Bern could decide which
one would run as president and which would be the V.P., they could run on the Peronist
party ticket.
This same sort of Mother Nature fooling doesn’t work any better in Europe and
Japan than here in the U.S., and in those places it hasn’t even made their rich that much
richer. Nevertheless, populism seems to be increasingly popular globally as fringe
political parties move to center stage. Meanwhile, in the homeland, we are witnessing
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political debate which is increasingly substance free. While the U.S. could use a serious
adult conversation about policies that might spur economic growth, the focus is on
building walls on the Mexican border and taxing the rich. You can fool some of the
people all of the time….
ECONOMIC OUTLOOK
Following a highly disappointing first quarter (0.6% growth), the U.S. economy snapped
back briskly (to a 3.9% growth rate) in the second quarter. This brings year-to-date
growth in at 2¼%, not appreciably higher than the roughly 2% growth of the past several
years. This continues to be the slowest economic recovery since WWII. The rest of 2015
is also likely to see the economy grow closer to the recent 2–2¼% trend rather than the
near 4% growth of the most recent quarter. The slow growth trends in the U.S. are being
reinforced by a slowing global economy, especially in China. Recent revisions to both
longer-term U.S. GDP growth and U.S. industrial production lowered the rates of growth
to an even slower rate than the already anemic data had indicated.
While the U.S. does look to be more insulated from the slowing global trends than
other countries, the U.S. is unlikely to “decouple” from the international woes than many
see. While decades ago the U.S. represented well over half of the global economy, today
it represents less than a quarter. Exports now make up a tenth of U.S. output.
The recent sharp decline in energy prices will have a salutary effect on consumers
but will be mitigated by layoffs and reduced capital spending in the oil patch. Similarly,
lower food prices are helpful to offset the higher prices for health care, education, and
housing. Nevertheless, even while deflation looms, core inflation (food and energy)
slowly creeps ahead.
CFA expects a continuation of slow economic growth, low inflation, and low
interest rates. There are two excellent economic recession forecasting tools.
Unfortunately, one of the best is the stock market. While the stock market has forecasted
eight of the last five recessions (as Paul Samuelson famously said), there have been no
post WWII recessions without a preceding bear market. Using a 20% decline in the stock
market to forecast a recession isn’t much help. The next best recession forecaster is an
inversion of the yield curve which has a propensity to forecast recessions and bear
markets. Shown below are yield curves as of 9/30/15 as well as for six and twelve months
ago.
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Since the Fed is holding short rates down, one should focus on the 2-year/10-year part of
the curve: No recession forecast here either. We continue to watch this closely, and so
does everybody else.
Another (and newer) worry is China, which is now the second largest of the
global economies. Its rapid economic expansion of the past several decades contributed
mightily to overall global growth, and now its growth slowdown is contributing mightily
to the global slowdown. This slowdown is especially impacting emerging and frontier
economies who export natural resources to China. There are two issues to watch. The
first, and less important, is the stated growth of the Chinese economy, but nobody
believes the Chinese economic data in the first place. (See also above about the
downward revisions to U.S. economic data.) The second and more important issue is the
up-to-now ham-handed efforts by the Chinese to stimulate growth and manipulate its
stock markets. China should be cut some slack since it is newer to financial repression
than more developed countries.
The fact that everybody is trying to fool Mother Nature raises the stakes of
something going wrong.
INVESTMENT IMPLICATIONS
In our opinion, virtually every investment category seems richly overvalued to us. This is
only slightly less worrisome to us if interest rates stay low. While hard to tell, it seems
that the Fed’s decision not to raise rates at its September meeting may have backfired.
First, it increasingly looks like the Fed is being held hostage by the financial markets.
Second, the Fed’s credibility is becoming suspect since it has been threatening/promising
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to “normalize” interest rates for more than two years. And lastly, much like borrowing
has been stealing economic growth from the future for many years, there are now fears
that years of easy money have borrowed investment returns for the future.
A recent article, “Why You Shouldn’t Trust Most Financial Research,” boiled
down an academic paper by Campbell Harvey, Yan Liu, and Heqing Zhu, and questions
whether the “at least 315 ‘factors’ of investment returns have been discovered through
multiple regression analysis and published in hundreds of articles and working papers”
has any value. The authors, Michael Edesess and Kwok Tsui, wonder whether such
research shows coincidental or casual relationships, casting doubt on the value of
quantitative data mining. However, since investment products based on such possibly
spurious and specious data mining are being created by Wall Street, such research
becomes self-prophesizing—somewhat like technical analysis. There goes Wall Street
trying to fool Mother Nature with “smart beta” margarine.
CFA expects continued lackluster economic growth but international growth is
slowing, and that may negatively impact the U.S. Inflation remains low but has been
heavily influenced by declines in food prices and especially energy prices, which may
prove transitory even while deflation remains a concern. Interest rates are likely to stay
low, but a change in monetary policy is inevitable. Stock valuations appear fairly high,
and the technicals have deteriorated. All these factors lead us to want to err on the side of
caution. But don’t overdo it since no one knows what will happen next.
BOND MARKET OUTLOOK
CFA, like everyone, waits and waits and waits for the bear market in bonds, but it just
never seems to arrive. In fact, money continues to pour into bond funds at a much higher
rate than into equity funds. (Not that much has been flowing into equity mutual funds
recently.) Since the beginning of 2014, over $125 billion has gone into bond funds. The
U.S. bond market at $39 trillion is about 50% larger than the U.S. equity market. Since
2000, the U.S. bond market has better than doubled while the U.S. equity market has only
increased by 75%. Investment grade bonds are being issued at record levels with much of
the proceeds going to share buy-backs and increased dividends. A large portion of new
bond purchases are being done by index funds but indexing bonds often leaves you with
exposure to the most indebted issuers—the Federal government being by far the largest.
A recent “white paper” by Nuveen examined the last three periods of Fed
tightening. (Interestingly, there have only been three such tightening episodes since
1994.) The major observations were:


Shorter maturities increased more in yield than longer maturities in all three
periods.
Shorter maturities’ total returns were greater in the two earlier periods but
underperformed in the most recent tightening.
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
Total returns were positive in all six (1-year, 3-year, 5-year, 10-year, 20-year and
22+-year maturity) benchmark periods.
Nuveen’s conclusion: “patient investors who held bond portfolios through rising rate
cycles generated positive returns.”
In general, we favor a barbell approach to bond investing, owning shorter duration
bonds (especially through ETFs and ideally in a ladder) balanced with longer-term (20year plus maturities) holdings. Remember that most of the time, investors are buying
bonds to generate income and to provide stability to their portfolios, not to make a fast
buck.
The best single indicator of future bond returns tends to be the current coupon
yield, so returns are likely to be low. However, as quality declines, risk rises so don’t
reach for yield. Make sure the risks you are taking by (potentially) buying lower-quality
bonds is commensurate with the risk you are willing to assume. Don’t be fooled by
higher yields; they indicate higher risks.
STOCK MARKET OUTLOOK
It’s (also) not nice to fool Market Nature. Besides the Federal Reserve’s policies of
financial repression and market manipulation, investors have to deal with any number of
new stock market forces from the proliferation of hedge funds, to the growth in
quantitative methods and high frequency trading, to all manner of questionable methods
of “spoofing” and front running. An increasing amount of stock market trading couldn’t
care less about the fundamentals of the economy, market valuations, and the underlying
companies being bought and sold. Add in the near hysterical media coverage and you
have a veritable witches brew of investment cross currents to deal with.
Many investors have decided to just index and forget it. This trend has been
exacerbated by the declining number of active managers who have been able to
outperform passive indices. While indexing probably should play a role in most
investors’ overall strategies, indexing can be a bumpy ride and assumes investors will
stay the course and have no other goals than to match the returns of some index. Which
indexes should you use? What about diversification? Income needs? Tax considerations?
Shown below are two sets of charts which we’ve shown before.
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The first shows a five-year pictorial of the S&P 500 with simple 50 and 200-day moving
averages. We have circled what is euphemistically called a “black cross” where the price
drops below the 50-day and 200-day moving averages and all are heading down.
Technically, you want to be out of investments showing such a technical pattern. (For
example, since the XLE [the ETF for the energy sector] did a “black cross” in October of
2014, it has declined by more than 20%, considerably more than the S&P 500’s 6%
decline.)
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The second chart shows the Baseline (10-year) “Best Fit” model for the S&P 500.
It shows an S&P 500 that looks to have about 4% downside risk due to valuation (P/E
shown in the second frame). Also shown in the bottom frame is an earnings projection
which indicates a slowing trend in the earnings growth for the S&P 500. However, it still
shows forecasted earnings growth of almost 10% over the next twelve months (unlikely
but possible). Based on the highest P/E valuation of the past 10 years there is about 16%
upside potential (possible but unlikely) compared with 34% downside risk based on the
10.7 P/E at the (panic) bottom of March of 2009 (improbable and unlikely).
So we think that a new lower, but still exasperating, trading range is the most
likely outlook. Over the two years the S&P 500 has traded in a range of 2131 to 1862.
With the 9/30/15 close of 1920, we are roughly in the middle of that range. With lots of
cash on the sidelines, the possibility that U.S. investors might repatriate disappointing
foreign investment dollars with limited attractive investment options is slim; the U.S.
once again looks like the best house in a bad neighborhood.
While little has changed in terms of the slow growth, low inflation, and low
interest rate outlook, the attitudes of investors has radically swung from cautiously
optimistic to fairly pessimistic. Periodic bursts of fear–driven volatility have rippled
through the market recently. And while volatility has occasionally spiked, it is far short of
levels seen during even scarier periods in the recent past. There has been a surprising lack
of bearishness as the closely followed AAII data has stayed relatively neutral for many
weeks since this correction started and the State Street Institutional Investor Confidence
Index actually rose in September.
So, what to do? Well, if you feel that not much has really changed, stay your
course. If you think that the markets have over-reacted (they are prone to doing so), go
bargain hunting. Unfortunately, going bargain hunting means buying what is out of
favor—such as value, energy and materials stocks (yikes!), and emerging markets
(yuck!). If you feel the whole world is going to hell in a hand basket (and an ever
increasing number do), you should raise cash for the bargains that lie ahead (even though
you probably won’t buy them when/if they arrive). Additionally, you can vote for Donald
Trump and make sure that the world actually does go to hell.
Do not become overly pessimistic! This bull market has surprised almost
everyone over the past five years. Let’s try to be like the Who because they “Won’t Get
Fooled Again!”
October 1, 2015
John E. Montgomery
This information is not meant as a guide to investing, or as a source of specific investment recommendations, and Capital Fiduciary
Advisors, LLC makes no implied or express recommendations concerning the manner in which any client’s accounts should or would
be handled, as appropriate investment decisions depend upon the client’s investment objectives. The information is general in nature
and is not intended to be, and should not be construed as, legal or tax advice. In addition, the information is subject to change and,
although based upon information that Capital Fiduciary Advisors, LLC considers reliable, is not guaranteed as to accuracy or
completeness. Capital Fiduciary Advisors, LLC makes no warranties with regard to the information or results obtained by its use and
disclaims any liability arising out of your use of, or reliance on, the information.
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