Investment Outlook - First Quarter 2015

The Year in Review and the Year Ahead

Fearlessly Predicting the Unpredictable

It is that time of the year when the investment community confidently predicts what the unpredictable stock market will do over the upcoming New Year. Most of these predictions hug the average long term return on stocks of some 8-10%. This year's consensus forecast is for the market to be up 8.2%, according to The Wall Street Journal. Last year the average forecast was for the stock market to appreciate by 6 percent. That forecast proved to be about one-half the actual return. Very few forecasters stick their necks out and predict annual results far from the long term average. It may surprise some that the annual returns of stocks have exceeded 30% more often than they have been in the single digits. Annual returns on stocks are quite volatile, but forecasted returns rarely are. Have forecasters already forgotten the 37% decline in 2008 and the less dramatic 32% gain in 2013? So what to expect in 2015 -- a single digit return of +8.2 percent?

Last year was the sixth consecutive year of positive results for the U.S. stock market. It is unusual for the market to have a winning streak of this length. Most major stock indices are now at all-time highs. It therefore seems timely to revisit, as we did last January, four market barometers that typically are symptomatic of an overheated market. These four readings of an unhealthy market include:

  1. Economic Stresses. As we said last year, a significant decline in economic growth (e.g. a recession) or its evil twin -- an overheated economy -- cause problems for stock markets. We had neither extreme in 2014 and expect the same will be true in 2015. However, global economic growth is on shakier ground today than a year ago. China is slowing. Europe and Japan remain comatose. Problems are mounting in emerging economies, such as Russia, that are struggling with lower commodity prices. Investors are likely to focus on and react to developments in international economies as the year unfolds.
  2. Interest rate pressures. Last year we thought that higher interest rates would become a budding negative for the stock market. The forecast by some 50 economists last year was for the 10-year U.S. Treasury bond to finish 2013 at a 3.5% yield. Actually, the 10-year Treasury bond finished at a 2.1% yield. Low interest rates remain the primary fuel propelling this bull market in stocks. Although nearly all forecasters expect the U.S. Federal Reserve to start to raise short term rates in 2015, the weakness in global economies leaves the timing of higher rates up in the air.
  3. Excessively high stock valuations. Last year we viewed valuations of the broader market to be neither undervalued nor at an excessively high level. Currently, valuations in the broader market have drifted slightly higher as prices have advanced more than earnings. Valuations are not in the red hot danger zone, but further gains in the market need to be largely driven by earnings growth, not a higher price for earnings.
  4. Unbridled investor enthusiasm. Last year we saw enthusiasm visibly escalating for many small, fast-growing companies. This enthusiasm subsided for many companies and industries in 2014. For example, last year we identified eight companies in the Outlook that we thought were the poster children for overvaluation. Seven of these eight companies declined significantly in 2014 -- four declined by some 50% or more. The Russell 2000 which tracks the performance of smaller companies posted a mere +3.5% price gain in 2014, or 10 percentage points behind the broader index of larger companies.

Dealing with the Unpredictable Short Term

Although it is customary to make annual forecasts, it is next to impossible to make accurate forecasts on what is going to happen in the stock market over the next twelve months. A more important exercise is to objectively evaluate the unpredictable events that might unfold during a year. As we mentioned above, interest rate forecasts were way off the mark last year. But, perhaps the most surprising development during the year was the 50% decline in oil prices. This decline has left experts, many of whom forecasted no decline in prices, wondering if there is more to go on the downside, whether prices will remain near this general level, or perhaps whether there will be a sharp recovery back towards the $100 level. We are convinced that predicting oil prices is a fool's game. The closest we can come to a forecast is to adhere to the old notion that high commodity prices ultimately cure high prices and vice versa. Some adjustments by oil companies are already occurring. Nonetheless, there will be harsh realities for some companies and countries coming to light early in the New Year if prices remain in this range. There will certainly be offsetting benefits to countries and companies from these lower prices at some point. In the near term, however, negative news from the oil sector will preempt more sanguine developments later on.

Summing Up

Compared to this time last year, we find that global economic growth is more uncertain, interest rates are more likely to increase from very low levels, valuations are generally less attractive, and investor speculation is apparent but spotty. However, as the GEICO television ad says "everybody knows that." In other words, the market has already priced in these consensus expectations.

So is there a more positive alternative scenario? For starters, although the U.S. stock market is at record highs, expectations are quite low for any positive global economic changes. Forecasts for global growth have been revised down year after year for the past few years. Could Europe finally make more progress politically and economically than gloomy investors expect? Can China's decelerating growth still exceed 7%? Will commodities stop declining and settle into a range? Could U.S. interest rates once again surprise by declining rather than increasing? Stranger things have happened economically. At the company level, dividend growth for many companies has been remarkable -- will U.S. corporations continue to reward investors with higher dividends? Although low rates have been the major factor pushing markets higher, higher dividends have also been a major contributor. A positive stock return in the New Year would be the seventh consecutive year of positive returns. The longest streak in the last 90 years was nine years, ending in 1999. To end on a cheery New Year note, we will lean on the maxim that "records were meant to be broken." Even a consensus predicted return of +8.2% would fit the bill.

Happy New Year.

Bob Milnamow
President and
Chief Investment Officer
January 2015