Let’s assume that on January 1st 2014 I told you the following would occur by year-end:
- The 10 year U.S. Treasury Note would end the year at 2.17%, down 86 bps.
- The yield curve (10 year U.S. Treasury minus the 2 year U.S. Treasury) would significantly flatten 115 basis points from a start of 2.65% to 1.50%.
- As measured by the Bank of America Merrill Lynch U.S. High Yield Master Option Adjusted Spreads, high yield bond spreads would widen 104 basis points from a start of 4.00% to 5.04%.
- Crude oil would fall 46%.
- The CRB Commodities Index would fall 18%.
- S&P 500 earnings estimates for 2014 would come down 4% from the start of the year and 2015 estimates would come down 5% from where they started the year.
Where do you think the S&P 500 would end up? I can promise that you would probably not say 2,059 for a total return of 13.69%. At the start of 2014, consensus was for higher rates representing an acceleration in growth, which would lead to higher equity prices. Well, the higher equity prices were correct, but I would argue it was not due to an acceleration in growth. Every bullet point above is screaming slower growth in the future.
The year of 2014 will be looked back on as the year of disconnects. The credit and commodities markets are saying one thing, while the equity market says another. Eventually, one of these markets will be right and reverse course. When will this happen? I have not the slightest clue. It could be next week, next month or 5 years from now. Clearly, the path of least resistance in the equity market is higher at the moment. However, if growth does not reaccelerate from here, it will be increasingly harder to justify paying higher multiples for decelerating growth. Our valuation models have been warning us of a deceleration in corporate earnings growth for well over a year now. We are typically early in identifying trend changes, which is why cash levels remained elevated throughout the year even though the S&P 500 continued to rise. It is becoming harder and harder every day to find new opportunities for the cash. As long as valuations keep rising in the face of decelerating growth, we will continue to be net sellers. I promise you, patience and discipline will be rewarded one day.
As for 2015, what does the future hold? I’ve never been big on making market predictions. Part of the reason is we are a bottom up manager, so getting individual companies right is more important than where the S&P 500 is headed over the next year. However, I do believe there is a decent probability volatility will become the buzz word again in 2015, which leads to the first stock market correction (10% or more) in over 2 and a half years. In turn, the Federal Reserve will not increase the Federal Funds rate in 2015 and in fact, may very well re-introduce QE. The wild card in this scenario would be the reaction of the equity market. Do we see much of the same, a swift recovery in equity prices or does the equity market not react to the latest Central Bank intervention? This is a question I suspect will be answered this time one year from now.
In the meantime, we will continue to work diligently on your behalf and trade proactively as opposed to reactively. When opportunities are present, we will take advantage and put some cash to work. Otherwise, we will continue to trim over-valued positions and bide our time.
Billy Little, CFA
“It requires a great deal of boldness and a great deal of caution to make a great fortune, and when you have it, it requires ten times as much skill to keep it.” ~ Ralph Waldo Emerson
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