RGA Investment Advisors: December 2014 Investment Commentary: Our 2015 Investment Outlook by Elliot Turner
RGA Investment Advisors: The big events of 2014
In 2014, the S&P 500 returned 11.4% in what appears like a steady continuation of the bull market that began in March of 2009. This is somewhat misleading. Some of the broader and global indices are more representative of what the year was like in equity markets: the Russell 2000 returned 3.5% during the same time-period, while the MSCI World Index eeked out a 2.9% gain. The year started with Emerging Markets showing signs of trouble, dragging down the S&P alongside. Momentum stocks rallied aggressively early on, before a blow-off top in late February. Momentum issues then experienced a rapid unwinding to much lower levels. The recovery in these stocks has been disparate and for the most part, tame, with biotech the notably strong exception. Commodities collapsed throughout the year with iron ore looking particularly bad throughout. Meanwhile, crude oil’s late year slide stands as one of the most notable market moves which will surely have consequences for years to come. The U.S. dollar rallied mightily to multi-year highs in the second half despite prognosticators perennially declaring its death. Absolutely no one predicted interest rates would fall in 2014, but fall they did.
2014 was a year in which the unpredictable happened frequently, with almost an air of predictability. It was a year filled with proverbial minefields where most investors were forced to “dodge bullets” more so than generate significant returns. Our 2014 outlook proclaimed, “it is quite possible, almost probable that 2014 will be a better year for the economy than it will be for the stock market.” Despite the S&P’s double-digit return, we think the story played out largely along these lines. Our 2014 outlook further explained that, “While we did not see the economy’s traditional metrics of success reach ‘normalized’ levels in 2013, it has been clearly positioned for the long awaited, but elusive escape-speed breakout from the Great Recession.” Weather threw a wrench in the economy’s trajectory early in the year, but once that headwind lifted, a crescendo of accelerating growth commenced.
For the most part, 2014 concluded with the U.S. economy on as solid a foundation as it has been in years, though we continue to expect markets to be weak and volatile compared to the economy. It is important to remember the economy and the stock market do not necessarily move in tandem. In our notes below we will both cover what has happened in the recent past and what we are prepared for moving forward. Take any remark about the future with a grain of salt, for we perceive these expectations as a series of hypothesis from which we structure our portfolios, but never lever them to. We think it is extremely important to remain flexible enough to revise any thesis; as John Maynard Keynes once said, “when the facts change, I change my mind. What do you do sir?” Our investment decisions are always based on the bottoms-up fundamental analysis we do on individual companies; however, these macro questions provide an analytical framework through which we can hone in on areas with promise and avoid undue risk.
RGA Investment Advisors: A visual overview of stocks and the economy
Earnings (not the economy) drive the stock market:
Many complain about the market’s strong performance relative to the economy since the March ‘09 bottom. We think this perspective is flawed due to incompleteness and ideology. A common gripe maintains the market’s performance is merely the outcome of aggressive monetary policy. Cause and effect in markets is never simple and always dynamic. Such a simplistic argument ignores the most significant long run driver of stock markets: earnings. Since the March bottom, the S&P has closely tracked the trajectory of its earnings per share, with earnings actually leading the way most of the time.
Importantly, this is the most significant driver of stable stock returns over the long run. Take a look at the S&P verse earnings since 1960. The index has deviated over time, most notably in the dot.com bubble era; however, each deviation has been met with the market reverting back towards a steady trajectory relative to earnings. Recently the market has moved slightly ahead of earnings, yet once the fourth quarter of 2014 is reported this will look more benign. Further, this discrepancy will be relatively small such that it can be worked off with the kind of volatile sideways action we expect.
Industrial production is surging which supports the rise in EPS. Notice that the chart below looks a little like the S&P (though with a more persistently positive slope). Also notice how severe the impact of the Great Recession was on production. It’s worth repeating yet again that this was no run-of-the-mill recession. This one chart is great proof that this recovery is real and the claim that this is merely a result confined to asset prices is wrong.
The Strong Dollar Yellen Fed (take THAT conventional wisdom):
In the same vein that people complain about the market’s performance verse their perception of the economy; they similarly bemoan the impact monetary policy is expected to have on the value of the dollar. To that end, people have been calling for the demise of the dollar, dollar doom, and the end of the dollar as a reserve currency. Remember when it was conventional wisdom that the U.S. dollar had only one way to go and that was down? In 2014 the dollar reached its highest levels on a trade-weighted basis since before the Financial Crisis (below).
This all happened despite the growth in money supply and is contrary to what textbook economics says will happen in a vacuum. People point to a plethora of reasons behind this move ranging from a flight to safety out of struggling global economies, technical trading action, a strengthening U.S. economy, and a divergence in monetary policy between the US and the rest of the world. As is often the case, no one reason is the answer—a little bit of each of these factors adds up to a strong move.
Will 2015 hammer the final nail in the “secular stagnation” meme?
One thing economists look at to measure the depths of the Great Recession is called the GDP output gap. In the chart below, the spread between the two lines represents the degree to which the economy is underperforming its potential. Notice how closely the blue and red lines tracked each other until the Great Recession. This was distinctly not a run-of-the-mill recession. When people speak of “secular stagnation” they mean the blue line will permanently stay below the red line. Further, they mean the red line should be redrawn to reflect a new permanence to the lower growth trajectory (as it has in below). Though the blue and red have yet to converge, 2014 went a long way towards easing concerns that they never will. The efforts