Positions For 2015: Still Plenty Of Life In The ‘Aging Bull’
[This post originally appeared on Seeking Alpha as part of their acclaimed yearly positioning series. It is republished in full below for the convenience of our readers.]
Over the past two weeks, Jeff has engaged in an email interview with Seeking Alpha’s George Moriarty, and we are pleased to share his thoughts below. Enjoy!
George Moriarty (GBM): First, thank you for once again participating in our series. We really appreciate you taking the time, especially since you already spend so much time working on your WTWA series.
Jeff Miller (JM): I appreciate the opportunity to join in. I always read the entire series for the rich variety of viewpoints and great ideas. The high standard encourages all of us to sharpen our thinking before responding, so it is a valuable start to the year. I always spend a lot of time on this, but it is well worth it for my own thinking. I always learn something from the discussion and comments as well.
GBM: You use economics as part of your investment positioning. What does that imply for 2015?
JM: If I had to pick one theme, it would be the toughest challenge for investors: Staying in the market with a normal asset allocation. So many articles and commentaries refer to the “aging bull” and “lofty” stock prices. It is yet another play on using a simple heuristic to guide investments. It sounds good, but it is mistaken.
GBM: In your weekly series, you focus keenly on important economic themes and put them in context for your readers. What do you see for this year?
JM: It is not a dramatic forecast, but it is very constructive. The main economic theme is that there is no expiration date on the business cycle. Major stock downdrafts come after a cycle peak. The best indicators show to be at least a year away. The current economic expansion could go on for years, especially if there is plenty of worldwide weakness. We could easily be having this same conversation a year from now, with the economy growing and the market 15% higher.
Why is the business (and stock) cycle longer? The sharpness and depth of the decline and the slow and gradual recovery. This should not really be a surprise.
GBM: Does your analysis imply a stock price target for 2015?
JM: Heh, heh. Every stock price forecast should come with an error band of +/- 15%! That is just normal volatility. Unlike the featured Street strategists, I do not wait for a target to be hit before adjusting. I always have a base case and adjust as I get new information. One factor is the falling estimates for energy stocks. We’ll know more in another month.
The base case is S&P earnings of $126.80. If earnings grow by 8% and you apply a forward multiple of 18 (often achieved in bull markets) you get a 23% increase. Let’s call that the high part of the range.
Jeremy Siegel’s call for Dow 20K next year could easily be right. It is approximately the historically normal increase. When I made my Dow 20Kforecast in 2010 it was based upon the odds of the market doubling versus being cut in half. I do not know if it will happen this year, but it will happen.
GBM: Would you predict Dow 35K before Dow 8500, essentially the same thing you called in 2010?
JM: Another trap question! In general, that is always a safe call. We will see another recession along that path, so it is a little premature. Following the quant corner in my weekly WTWA should be helpful in dodging the next recession-linked decline. We’ll take another look then.
GBM: As we head into 2015, where do you think the U.S. economy is, relative to the rest of the world.
JM: Normal growth is about 3% and there is a long-term mean-reverting trend. That is the base case for most economic forecasts. The underlying factors are population growth and productivity, so there is room for debate about possible trend changes. The US is not like Japan on these factors. Immigration is a consideration.
A common mistake is to think that the natural state is recession, saved only when there is massive government intervention. This comes from talking pop economics instead of analyzing data. Plenty of the top-rated financial sites embrace this theory. Fear sells.
GBM: What is the greatest risk facing the economy right now?
JM: For starters, it is not what most people are citing. There is a general perception that Europe and China will drag down the U.S. This is a popular theme, especially among non-economists with an agenda, but it is virtually without precedent.
The biggest risk is something we do not already know about. In recent years, these have included extremely unusual weather effects like the polar vortex or the Japanese Tsunami, an international crisis, or a terrorist attack. These “black swan” events can (and will) always occur.
Critics of economic forecasting often observe that the standard macro models do not allow for recessions. True enough. The best-performing models predict that the long-term trend of economic growth will resume. Recessions are a shock to that system, and therefore worth special attention. None of the best recession forecasting methods are flashing a warning for 2015.
But let me flip this. Nearly everyone talks about downside economic risks. There are also some significant “upside risks.” I have written about this concept in the past, but it is neglected by most. The impression for the average investor is the potential upside is limited, while we might have a crash at any moment. Here are some examples of good surprises:
- Housing is still dragging. What if it finally shows significant improvement?
- Government spending has been a drag, especially at the state and local level. What if it gets a little stronger through higher revenues?
- World events could get dramatically better, especially Ukraine. What if a solution were to be reached? Reciprocal sanctions ended? European growth fostered? A better market for China? My ballpark estimate for this alone is about 10% for U.S. stocks.
And these are only examples. Investors should engage their critical thinking skills, noting articles that do not even consider upside surprises.
GBM: What do you see as the major catalysts, and major risks, that investors ought to monitor in 2015?
JM: The biggest surprise last year – and it affected everything else – was the persistence of low long-term interest rates. Almost everyone was wrong about this, including me. I expected a stronger economy with the traditional shifting from bonds to stocks. I was right about the economy, but not about rates. There is always a danger in sticking with a failed forecast, but it is time for a reality check: Would you lend money to the US government for ten years at 2%?
Neither would I. The most important thing to understand about the markets in 2015 is the dynamic relationship between interest rates and stocks. Why are rates so low?
Let us start with what happened:
- Continued low inflation
- Continuing fear of stocks with a preference for the perceived safety of yield
- European arbitrage
The last factor is the most important. If you have the ability to borrow in Europe (selling high-priced bonds with low yield) and lend in the U.S. at a higher yield, your only worry is currency risk. Dollar strength lets carry traders “go commando” and even use leverage. Individual investors in Europe may also show a preference for U.S. investments. [Important note: Nearly everything the average investor sees about the “carry trade” is wrong – mostly because they cite examples of the US as the “funding country.” ReadMark Dow for a great explanation.]
Result: Asset classes emphasizing yield (e.g. utilities) showed strength. Assets responding to economic growth and/or without dividends showed less strength. This helpful interactive tool from Morningstar shows how the overvalued sectors became more so as well as where things stand now.
While valuation methods vary, some time spent with this tool will be profitable for investors.
GBM: About two weeks ago, you penned a mid-week column on “Crucial Facts About Energy Stocks.” In that, you laid out where you see opportunities in the sector. While I’d encourage everyone to go read that, can you tell us how you’re looking at energy now? And if any of the political or currency strife in certain countries has changed your view on the sector?
JM: There are three different levels for our consideration.
- Oil prices. The normal supply/demand equation has lost relevance. The leading expert on this topic, Dr. James Hamilton, originally estimated that economic weakness contributed about $20 to the decline in oil prices. Another top source, The Schork Report, says that the market has been “broken” for three months. Stephen Schork notes that there are bets on prices falling to $20/barrel.
- Exploration stocks. These are the most leveraged to prices, with the biggest reward if prices reverse. ESV is the best of the breed.
- Other energy stocks. Some of these actually benefit from lower oil prices, but get dragged down as part of an ETF. Valero Energy Corporation (NYSE:VLO), Marathon Petroleum Corp. (NYSE:MPC), Chevron Corporation (NYSE:CVX) are all good examples. Maybe Exxon Mobil Corporation (NYSE:XOM).
- Related stocks perceived as having economic sensitivity. This includes a long list of deep cyclicals and material stocks. Freeport-McMoRan Inc. (NYSE:FCX), Cummins Inc. (NYSE:CMI), Caterpillar Inc. (NYSE:CAT) are all good examples.
I started with no position in energy stocks, but bought a little after the initial decline. It was a gentle initial position. Wrong! Anything was too much.
Since then I have not added, but I am watching closely.
GBM: What signals are you watching?
JM: Anything that might affect the carry trade, including the following:
- European stimulus
- China stimulus and growth
- OPEC policy
- The dollar
And other things that I see in daily trading. How ETFs move versus individual stocks. There is an opportunity for those watching carefully. You really need to distinguish between three approaches:
- Pension funds
While we have been discussing this article, my viewpoints have not changed but the market has gyrated wildly. The start of the week was dominated by the trading guys. The latter part by the value guys.
GBM: What other themes are you monitoring as we enter 2015? Are there areas of opportunity that investors are missing?
JM: Here are some things that will probably happen
- The Fed starts to raise short-term rates, a process that will be gradual and will take a couple of years. There will be a knee-jerk negative reaction describing the reduction of stimulus as “tightening” and warning that you should not “fight the Fed.” This will create yet another dip to buy, since markets usually rally for many months after the start of a tightening cycle. If utility stocks have the same dividend but interest rates go back to 3% on the ten-year (where we started last year) that implies a 21% stock decline – and it is not coming back. An increase to 4% would mean a 35% decline. I am not worried about interest rate effects until the 10-year gets to the 4-5% range.
- Wages move higher. This healthy sign of an improving economy will be heralded as the first indication of incipient inflation.
- The Fed may start a reduction of the balance sheet, probably by not reinvesting maturing holdings. Another opportunity for the Fed pundits who have been wrong all along to continue their streak.
- More normal stock market volatility. The modest dips of 2014 are depicted as scary corrections. Investors should be prepared for a historically normal correction in the context of a bull market. This means 15-20%. And don’t expect to guess when it will happen.
Implications for 2015
Markets hate uncertainty, but that is the story on the interest rate effect. Expecting rates to rise has become a prediction without a time frame – not a good forecast, but no one really knows. Here is what to watch for:
- Stronger European growth
- Hint of weakness in the dollar
- Ukraine resolution
Things could shift quickly if the “hot money” is pulled out of U.S. bonds.
As to what investors might be missing, most of them remain under-invested in stocks and scared witless. This may seem strange to say with the market hitting new highs, but the participation has been narrow. There is (yet another) bogus chart making the rounds showing a record high in stock investments.
Consider how the 2015 forecasts we have seen so far are treated. Barron’s had a cover story with a panel of experts predicting quite modest increases in stocks, but the response was, “Why no bears.” I just watched a CNBC interview where an institutional market strategist said he expected a gain of about 10% next year. “So you are really bullish,” was the response. Everyone has been trained to expect something negative.
A popular blogger published a list of the five most popular charts from last year. They are all misleadingly negative and the highest rated one was completely wrong. I gave one of my Silver Bullet awards for the correction. People love to be scared, so the media delivers.
GBM: All that said, and since we’re looking at broad portfolio construction here, how are you positioning portfolios heading into this year? And what has changed since last year, if anything?
JM: First off, thanks for the opportunity to describe a bit more about what we do. We manage six different programs (not funds). Each investor has his/her own account with a blend of risk reward. For those who have already made it and are protecting wealth, we have a bond ladder. For clients who have stock portfolios, we have three levels of risk/reward:
- Enhanced yield – conservative stocks, reasonable yield, good balance sheets. We sell near-term calls to enhance the yield. The idea is to break even on the stocks and generate retirement income from dividends and call premiums.
- Thematic value stocks. This is an aggressive portfolio of things we expect to work in the near term. Under-valued by key measures. Reasonably safe for the long-term investor.
- Aggressive stocks. Companies that have great prospects, but there is a blemish. Maybe it is a drug trial. Or management. Or a review of earnings. We like the company, but there is more volatility. Current holdings includePCYC and ISIS, just to give the flavor.
We expect good risk-adjusted returns on all programs, but we will remain agile of the recession or financial risk odds change.
GBM: Finally, as the “Old Professor” you have always had an eye on politics. Some argue that politics is as much a threat as it’s ever been today. Where do you see the interplay of politics and investing today?
JM: There is a positive aspect that few are considering – a bit of bipartisan cooperation. We are already seeing this with more GOP confidence leading to less brinksmanship – which the market hates. Increased GOP control also has increased a sense of responsibility and accountability going into the next election.
A possible outcome is that we will actually see some legislative compromises. There is a long-standing theory about the “minimal winning coalition.” It means that legislation needs enough compromise to get the votes on board. A good recent example was ObamaCare, which included several compromises to get a filibuster-proof majority in the Senate, across party lines. There is some early evidence on the tax reform front.
A secondary political issue will be the start of the 2016 Presidential campaign. (Already??) The market reacts and over-reacts to these stories, so expect anything negative for Clinton or positive for Warren to weigh on big banks.
On the international front, the biggest example is Europe. Most people simplify the analysis of other countries by imagining a policy formed by a single leader – like a chess player. Since this is their mindset, they find it persuasive when TV experts explain things in those terms.
Those who are willing to reflect a bit will readily see the error. Suppose a foreign citizen were trying to draw conclusions about the U.S.? They might think that policy was strictly that of the Obama Administration, when there are many internal debates as well as disagreements, with the GOP, the liberal wing, the Tea Party types, etc. Other countries have similar diversities. European policy, for example, is the result of bargaining and negotiation…
Those studying political science or organization theory learn this in an early class. Business leaders and traders never took those classes. Investors would do well to ignore the popular press and do some independent thinking. Countries that have a lot at stake will negotiate to reach a solution. The leaders are not stupid.
GBM: Each week’s WTWA has a final thought. Do you have one for 2015?
JM: There is plenty to worry about, but that is not unusual. Let me suggest an idea about stocks that I have not seen elsewhere:
Take the major market sectors. Go short those that were the leading picks last year and go long the laggards.
Most investors will be doing the exact opposite!