Stocks And Bonds Fall – Decidedly Non-Consensus Views For 2015


Stocks & Bonds Fall – My 2015 Outlook by David Schawel CFA of Economic Musings

If we are to use recent history as a guide, something that’s all too popular but rarely a good idea, investors should expect continued gains in equities in 2015 with the best exposure being index funds. Institutions gun-shy from the financial crisis have missed out the full run-up in stocks since 2009 with many of them having large amounts of hedge fund exposure that only captured part of this historic rally.

Hindsight analysts now proclaim “You would have been better off in an index fund without the crazy fees” – and they are obviously correct in that assertion. With the S&P nearing 2,100 nobody remembers the plethora of bear arguments over the last five plus years (hello Greek debt crisis, fiscal cliff, tapering, and more). Of course today all that matters today in the average investors mind is how they’ve done. To my knowledge there’s no bonus points for being “right” or “smart” if the P&L that accompanies it has suffered. There’s no shortage of brilliant managers who have fought the Fed and lost miserably.

Regardless of why your thesis has or hasn’t worked out, we’re sitting at the end of 2014 with 30y yields under 3% and the S&P nearing 2,100. The market seemingly believes there’s no ceiling for stocks, and it’s becoming more & more accepting of low long term treasury yields. The question is what will happen going forward – so here’s some of my thoughts:

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  1. Negative returns for both the S&P 500 and the 10yr UST.

This hasn’t happened since 1969 but I believe it will happen this year. I am by no means predicting a crash for stocks, but it isn’t difficult to foresee them lower by 5-10%. Does this mean I’m bearish on the economy? No, not at all. I actually see continued improvement, albeit small. Similarly, for longer UST bonds, the long end of the curve has flattened tremendously during 2014. We ended last year with the 30y at 4% and the 10y at 3%. It was very easy to buy duration with that much slope, and many thought I was crazy to advocate buying 30y California zero coupon munis! Today the 10yr UST sits at ~2.15%. Assuming a duration of 9.5, the 10yr yield needs to rise by about 25bps (factoring in a small roll) for a negative total return. Does a 10y yield of 2.40% seem outrageous? Not at all, but I also don’t see a dramatic rise in rates either.

  1. TIPS will outperform nominals

If I recall correctly, TIPS have underperformed nominals 8 out of the last 11 years. Next year that will change. There’s been a dramatic repricing in TIPS breakevens with the 5y BE currently at 1.20%. In my opinion this is a very cheap option on inflation, and one that has very little downside.

  1. Oil won’t fall to $40, but it’s also not a screaming buy

I am admittedly no expert here, but my feeling is that the dramatic move in oil is over. Maybe it slips a bit more, but the calls for $30-40 oil will not happen.

  1. If you must own bonds, owning the 3-5yr will payoff

There’s a decent amount of slope at this point of the curve, and I’m still of the feeling that rate hikes either won’t materialize as quick as expected, or if they do the market won’t stomach more than one hike. The roll plus income on this point of the curve isn’t super attractive, but should generally shield investors.

  1. Volatility sellers will face a tough road

Volatility has been suppressed in this market and it’s by no accident. Through the Fed’s QE program, the “greatest volatility sale” ever has occurred through the purchase of trillions of MBS without hedging them. Attempts by the Fed to normalize policy will lead to higher implied volatility in many corners of the market.

  1. Hedge Funds will look a lot better

Going back to my first bullet, I foresee 2015 as anything but an easy year for the average “index” investor. Hedge funds as an asset class will do well versus indices, and much of the scrutiny they’ve gotten will tone down.

  1. Financials will perform well

While financials have performed well since the crisis, they also haven’t traded to historically high multiples such as biotechs, etc. Many of these financials can earn a sufficient ROE in this rate environment with positive optionality should the short end of the curve rise.

  1. Cash has a place

Unless you have the industry knowledge to pick the winners and losers within energy, chances are there’s nothing so cheap out there that you shouldn’t have some dry powder. Opportunities will open up during various points of 2015, and there’s few things as frustrating as being fully invested during a volatile selloff.

  1. EM bonds are buyable

Difficult to buy in this environment given the carnage, but opportunities are available in various EM debt funds such as ELD and EDD. Many are reluctant to buy this local debt given the rapidly appreciating dollar, but over time I believe this will prove to be a good buying opportunity and risk diversifier.

  1. We will all be wrong (in some ways)

Each year events happen that participants wouldn’t have expected. In 2013 it was the speed of the rise in interest rates, and during 2014 it was the speed in which the oil market repriced. Understanding that outside the box events happen regularly is important, as is the ability to change your mind as the facts change.

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