Market Perspective for 1.9.15
- I am not concerned about the stock market’s rough start to the year because January 2014 also got off to a bad start and yet finished the year 13% higher. I am more concerned that this recent selloff occurred just three week after the previous one, and fewer stocks rallied between December 15th and December 26th. Increasing frequency of declines and fewer stocks participating in each rally are signs of the market topping. By contrast, between October 2011 and September 2014 corrections occurred about every 3-5 months and every bounce had more stocks making new highs. The sharper correction we saw in October 2014 probably marked the end of the acceleration phase of this cyclical bull market. That said, the topping process can take several months.
- Again this year just about every market strategist has come out for higher interest rates, and as usual interest rates have fallen. At this point, I’d ignore everybody who says anything about bonds whose last name isn’t Gundlach or Hunt, because they’ve probably been wrong. If either of them tells me bond yields are going to rise, then I would start taking that position seriously.
- Also, when the credit spread stops narrowing I believe you need to sell high yield bonds. The credit spread is always in motion – it does not spend several months at cyclical lows. Too many strategists recommended lower credits in 2014 because their yields were greater and the economy was still growing. Markets anticipate. Just as stock prices head lower before earnings peak, typically, credit spreads start widening before the economy crests. Therefore, you need some high quality duration to protect your portfolio from a potential decline in the equity market, because no other types of bonds will do that. Do not forget municipal bonds in your quest for high quality duration.
- I have been concerned (and still am) about what might happen as a result of the rapid fall in oil prices. Other than the junk bond sell-off (the energy sector was the largest junk bond issuer by far in the last five years), we haven’t seen much fallout beyond energy company shares. If there are banks or hedge funds in trouble, we may not know until it becomes a crisis (the Long Term Capital crisis in 1998 and the Bear Stearns mess in 2008 came up all of a sudden), which could take weeks or even months. On the other hand, sometimes these “dislocations” can have a positive effect. Geo-politically we saw a historic thaw in the relationship between the U.S. and Cuba, no doubt helped by the fact that the latter can no longer rely on economic support from Russia and Venezuela.
- If any meaningful stock valuation anomalies exist today (by this I mean things that we will look back on in the future and wonder how we allowed prices to get that “out of whack”), I believe there are two leading candidates. One, the prices of lower volatility stocks/industries like utilities, consumer staples, and REITs versus more cyclical stocks/industries; and two, the valuation of U.S. companies versus those domiciled outside of the U.S. I understand why investors want low volatility stocks (studies have shown they provide more upside over time, and investors are still fearful of the huge drawdowns they saw in 2008) and I understand why investors prefer U.S. stocks today (our economy is growing at an apparently sustainable rate and our currency is strong). That said, these are two areas where reversion to the mean has always eventually occurred. Higher valuations lead to greater volatility because much more is expected from a stock trading at 22 times earnings than one trading at 12 times. A rising currency eventually discourages exports (your products become less globally competitive) therefore reducing economic growth. I expect each trend to continue well into 2015, and probably even strengthen. I’m just saying that the reversion (when it comes) is going to be highly investable because there is statistically a lot of room for cyclical stocks and foreign stocks to out-perform to get back to their historical average valuation relationships.
- Given the strength of the dollar lately, gold has not performed as poorly as I would have expected. This suggests it might be time to add a small amount to each portfolio.
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