January 2015

“It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’”

- Murray N. Rothbard, Economist

Science and Economics.  As hard as we try, the two don’t mix very well.  Yet, over the years, there seem to be three immutable “scientific” laws that govern investing:

  • An object in motion tends to stay in motion.
  • Things revert to the mean.
  • Don’t fight the Fed.

Wall Street’s version of these three laws would likely be:

  • The trend is your friend, and
  • What goes up must come down….and, vice versa.
  • Don’t fight the Fed.

Of course, these three laws are contradictory—and therein lies the rub as we try to look ahead into 2015.  What trends will continue and should therefore not be abandoned?  And conversely, what trends will reverse having run their course?  And, of course, what will the Fed do?

Against our better judgment, we will attempt to look ahead.  But first, let’s do a quick review of our January 2014 blog and see how we did.  Here is the heart of last year’s prognostication, having already acknowledged last month we miscalculated on interest rates (they didn’t rise) and energy prices (we certainly did not see a 50% drop coming).  So here’s last year:

After a 4-year bull run, it is hard to make the case that fear permeates the markets.  Still, it is pretty clear that in most stocks, euphoria and unwarranted momentum are not infecting the markets either.  If the lack of volatility is any indication, complacency seems to be the prevailing force as we enter 2014.

Central banks seem to be in control of money flow and interest rates.  The threat of a US government shutdown has ebbed.  Europe’s woes, while not solved, seem to have settled into a state of acceptance and slow recovery.  China’s ascent to Asian power is no longer in doubt—thereby mitigating Japan’s generational slide.  And while the Middle East can always flare up, there do not seem to any new Arab Springs on the near term horizon.

With this generally optimistic outlook we said “buy”—and 2014 turned out to be an above average year.  The S & P 500 posted double digit gains for the third straight year.  US GDP growth was solid and will likely come in north of 3% once the final figures are in.  Inflation remained low.  Unemployment fell and previously “discouraged workers” returned to the work force…or at least started the job hunt. 

In short, staying invested paid off, and those pulling back to wait for a huge correction missed again.

So, looking ahead, let’s examine the trends we believe have enough momentum to continue well into the New Year.  Let’s start with the big picture and then sift down to specifics.

  • China’s growth will continue to slow.  This does not mean contraction.  It means that China’s past double digit growth rate….which then fell to high single digits…then to 7% in 2014….will head toward 6% in 2015.  China’s economy is maturing, and as it does, some of the mal-investment of the go-go years will have to be worked off.  Plus, bigger economies naturally grow slower (by percentage) than emerging/smaller ones.
  • Europe will continue to struggle.  There is little to indicate either another deep recession or a robust recovery.  The European Central Bank (over Germany’s protests) will aggressively buy debt (as the US has) and expand their balance sheet.  Still, Europe’s unemployment rate will hover in the 11% range and the gap between the rich-north and the poorer-south will not narrow.  The European Central Bank Rate will remain at or near .05% (!).   This translates into negative interest rates (after inflation) in most European countries and absolute negative rates in others like Germany and Switzerland.  (By comparison the US Central Bank Rate is .25% and is expected to rise to .95% by year end 2015.)
  • There is hope that Japan’s “shock and awe” money printing experiment will yield positive results by Q4 2015.  We don’t see it.  “Abe-nomics” is not working; nor will it as long as the government continues to press on the gas (stimulus) and the brake (tax increases) at the same time.
  • Look for Latin American and South American growth to be in the 1-2% range.
  • In short, the global economy will continue in its “slowing trend” but will not contract.
  • This brings us the United States— and our 22%-23% contribution to world GDP.  Expect GDP to grow over 3% thereby continuing 2014’s trend.  (Remember, we went several years in the 1-2% GDP growth range.)  While many see danger in falling energy and commodity prices (layoffs in shale jobs + energy junk bond failures), we see the commodity bust leading to a US mini-boom.  Yes, that large swath of land from North Dakota down to Texas will feel pain.  And no, we do not wish their demise.  America’s shale boom is something we should all welcome. 
  • Still, it has been a lumpy recovery in the US over the past few years.  There are pockets of prosperity (think Seattle/Bellevue/Dallas) and pockets of blight (think Detroit/Cleveland).  Falling oil prices benefit almost everyone who does not directly depend on an energy job.  We therefore see the lumpiness smoothing out and the majority of Americans benefitting.  The savings on gas and energy is over three times the annual amount than the average pay raise to lower and middle class consumers.
  • We also see US Central Bank (the Fed) policies remaining accommodative.  Yes, the Fed is telegraphing rising rates, but we expect the first rate hike in Q4 of 2015 and not earlier.  And even if the Fed were to raise rates earlier, the steps would be so incredibly small it would not necessarily translate into materially higher long term rates.  Thus, the yield curve could certainly flatten in 2015.

The bottom line is, globally the US will continue to be the bright star on the global economic stage and this will be a strong point for the US stock market yet again.  We are therefore back to a modified TINA acronym….There Is No (better) Alternative, even if returns may be more modest.

For better or worse, CDs and super low yielding bonds can’t compete with stocks in this environment, as long as earnings remain on a stable path.  Many publicly traded Real Estate Investment Trust investors did well in 2014.  It is difficult, however, to see how REITS (being so market driven) can duplicate last year’s gains.  This does not mean real estate as a sector is stale.  Owning an apartment complex is a far different investment than a Wall Street REIT.  Just as we believe in owning individual stocks vs. mutual funds, we like specific properties vs. REIT baskets. 

The same discernment can also be said for stocks. After a 5-year winning streak, US stocks (in general) are more expensive than they were in 2009, 2011, or 2013.  More expensive, however, does not always translate into over-valued.  As company stock prices rose, many of the best also saw their top and bottom lines grow, thereby justifying the appreciated stock price.  The smartest worked as hard on the liability side as they did on the asset building side.  The old adage of price vs. value still applies.

Were we to try to get scientific (!) and reduce the coming year to a formula, it might look something like this:

Low rates + low oil prices + favorable Leading Economic Indicators + low inflation + political paralysis/gridlock = A favorable environment for stocks.

Moreover, this formula would allow for expanding multiples.  PE ratios can rise in this scenario thereby putting a floor under stock prices.

With all this said, here are some “random-yet-specific” predictions from Team Talbot:

  • Google begins to pay a dividend.
  • Oil prices fall then gently rise---starting the reversion to the mean process--and the energy sector will be one of the top performing sectors in 2015.
  • The ten-year rate will end 2015 at 3.5% ---and 30-year mortgage rates at 4.5%-5%.
  • Not only will the job market strengthen, but wages will rise.  Retail will benefit.
  • Business spending and CAPEX will rise, while share buy-backs will be scaled back substantially.
  • Mobile phone payments will catch-on….this will be considered the start of a multi-year trend.  Apple benefits.
  • The trade deficit will rise and the dollar continue to strengthen while import prices fall.  US manufacturers complain.
  • Home prices plateau but don’t fall.

So, the chances that we are right about all of the above is….scientifically zero.  But, somewhere in there, there are events that will take place.  The real job we have is to figure out what they mean to the value of the equity positions we hold and the real estate projects in which we are involved.  That is the art of the game.

Happy Investing!



View older posts.