2015: The Long Year of Nothing
2015 was a year where asset allocation came up empty. Generally speaking, if we spread our clients' money across multiple assets classes, some will do better than others, generating positive returns no matter what. This year, no asset class seemed to work. At New Year's Eve close, US stocks defined by the S&P 500 gained just 1.38%. Our January 1st forecast was 2%, revised to 6% in July. Earlier this week, it seemed we'd split the difference, but stocks slid 2% in the last two trading days of the year. So much for the Santa Claus rally!
The detailed recap of the world's markets is here. For a typical blended portfolio, the worst return since 2011. Without four top performing stocks - Facebook, Amazon, Google and Netflix - the S&P 500 declined 2.26%. Half of all S&P 500 stocks delivered negative returns, and 28% lost 10% or more. At the bottom, with declines ranging from 50-80%, were the independent oil companies whose revenues were clobbered by the 67% decline in the price of oil since July 2014. Trouble among oil companies depressed S&P 500 earnings, which gained only 0.3% in 2015 versus start of year estimates of plus 10%. Minus the energy sector, earnings grew 7%. Dollar gains against world currencies reduced the value of profits from overseas operations.
Why should 2016 be any better?
Much to worry about for 2016. Earnings are currently forecast to grow 8.3%. The Fed is expected to raise rates at least twice in 2016, possibly 4 times. We still have 10 months to go till the US Presidential election is resolved. The US faces both domestic and international terrorism. The Middle East is in flames from Algeria to Pakistan. The dollar may continue to gain given higher interest rates in the US compared to Europe and Japan. So far, so bearish.
Yet, Europe will more likely be in recovery mode over the next year. The worst expectations about China's slowdown have not come to pass. Ultra low energy and commodity prices are bad news for emerging markets, Australia, Canada and Mexico, but good news for US consumers. The US job market continues to improve at the rate of 200,000 additional jobs/month. However, the 5% reported unemployment rate is really closer to 8%. Consumer confidence delivered only so-so Christmas retails sales, yet US car sales are at the best levels since 2005 (combination of a need to replace old cars, lowest gas prices since December 2008.) Consumer confidence also is as the highest level since 2008, though that could turn lower in a heart beat. US market analysts expect stocks to rise 8.5% in 2016. We are more cautious, projecting gains of only 5%, which we'll revisit in July. For sure, having energy and commodity prices stabilize or go higher would boost overall earnings. As we always observe, the stock market ultimately only cares about corporate revenues and earnings, and interest rates.
Fed Policy
Investors applauded December's increase of the Fed Funds rate to 0.25%. This was the first increase since June 2004. In that tightening cycle, the target rate rose from 1% to 5.25% over the course of a year. We expect the Fed to be way more restrained this cycle. In 2006, inflation was 3-4%, surging as high as 5.6% in 2008, while labor was scarce with labor force participation rate at 66.5% (the record participation rate of 67.3% was recorded in March 2000, right at the start of the "decade of suck.") Inflation in the US in 2015 was 0.2%, and the labor force participation rate of 62.5% is at a low last seen during the "stagflation" 1970's.
It should be noted that rising Fed Rates do not necessarily kill bullish stock markets. US stocks had no trouble making record highs in 2006-2008. What killed that bull market had nothing to do with Fed Policy, everything to do with reckless risk-taking in the banking sector.
Clients' Confidence Levels
We spend a lot of time talking with clients about their goals, but we also hear a lot about their fears. Our clients are the most pessimistic we've heard since March 2009. Among their concerns:
- Job security, or lack thereof
- Stagnation of income growth, even as expenses rise
- Concerns that children and grandchildren will not be able to find meaningful employment
- Terrorism
- The 2016 Presidential election
- Bill Cosby is an alleged rapist
Regarding job security and income growth: there is no way to cushion the bad news. Thanks to technology and global communications, 320 million Americans are now in permanent competition with all 7.2 billion people on the planet. It's not a question of whether an immigrant will take your job, or whether your job will be outsourced to India or China. It's a question of: if an American can't do a job better, faster or cheaper than a non-American, then he or she is out of a job. Since Americans can rarely compete on labor costs, the only way to win is on expertise. So put down that video game controller, cancel your fantasy football subscription and take a class on how to program a process logic controller (a PLC is a digital computer used to control a broad range of industrial processes.) White collar workers are as much at risk as blue collar workers - ask anyone trying to make a living as a lawyer these days.
In 1999, a quarter of 25 year olds lived with parents. By 2013, that percentage doubled. The generation that graduated over the last decade left school with the highest levels of debt (average/student of $28,950) yet entered the worst job market since the 1970's and are generally under-employed. Meanwhile house prices are approaching the highs last seen in 2007-8 - good news for retiring parents, but bad news for first time buyers. "Failure to launch" includes the inability to marry, form a household, start a family, buy and furnish a home. We estimate reduced household formation subtracts 0.5% from annual GDP (2.4% in the most recent report, 2.1%/year average since January 2000, versus 3.2%/year in the 20 years through December 1999.
Al Qaeda, ISIS, Boka Haram are Jihadist terrorist organizations we've learned way too much about since 9/11. The recent attack by a deranged couple in San Bernardino led to ridiculous call to ban ALL Muslims from entering the country, while carpet bombing ISIS in Syria and Iraq. Here's the reality of the situation: jihadists are far more frightening to other Muslims, who bear the brunt of terrorist atrocities. The average American is more likely to be killed by, in increasing order of probability: a Christian terrorist, a police officer, texting while driving, being struck by a car, a spouse, relative or neighbor, suicide, the flu, random accidents, lung disease, cancer, and heart disease.
Jihadist terrorism is not an existential threat to the United States, anymore than a rubber dinghy is an existential threat to an aircraft carrier. Jihadism is more like mad cow disease, something to be quarantined and suppressed until it disappears over time (reasonably speaking a generation or two.) At recent Republican debate, Sen. Ted Cruz called for "carpet bombing" ISIS until the "sand can glow in the dark." The last time civilized nations employed carpet bombing was during World War II. Such tactics caused the deaths of 135,000 in Dresden, 40,000 in Hamburg, 200,000 in Hiroshima, 97,000 in Tokyo, and 129,000 in Nagasaki. Most of the casualties were civilian men, women and children, but also prisoners of war and other non-combatants. Modern rules of war simply don't permit indiscriminate slaughter. What is permitted is drone strikes and precision munition drops, a strategy employed by the US continuously since February 2002 and in the present day in Pakistan, Yemen, Syria and Iraq. Risk to non-combatants is minimized, but by no means eliminated.
The United States is the most important country on the planet, yet we run our presidential election like a particularly unpleasant version of the Gong Show. Among Republican and Democratic candidates, there is none of stature. By comparison, read over the biographies of US presidents since Eisenhower. Even George W. Bush, regarded by many historians as the worst president since Hoover, was governor of a major state and served in the US military (albeit a National Guard stint cut short by his enrollment at Harvard Business School.)
On the Republican side many of the candidates with actual government experience are already out (Jindal, Walker, Pataki, Perry.) Of those who remain (Christie, Bush, Kasich, Huckabee), none is polling more than 5%. Paul, Fiorina and Santorum currently poll less than the margin of error. The final four may well be: Trump, Cruz, Rubio or Carson. Carson briefly topped the polls earlier in the fall, but his campaigning reminded too many people of the creepy uncle at Thanksgiving no one wants to talk to. Trump is the current leader at the national level, and leads in most early primary states except Iowa, where Cruz recently pulled ahead. Rubio doesn't lead in any polls BUT leads in the prediction markets, which actually are more reliable than polls. Christie and Bush poll at barely relevant levels. It's not inconceivable that either could make a come back once actual voters cast votes. We believe that the early polls grossly overestimate who will actually turn up to vote. Trump's support could well be an illusion.
A few comments about Trump: No modern US candidate has acted like Trump, though his style of campaigning would not be out of place in 1930's Germany, Italy or Argentina. Those of us who live in New York City have known Trump for 45 years. He a BS artist, but so what if that's what it takes to sell overpriced condos to Japanese and Chinese businessmen? However, the idea that he actually COULD be president astonishes us. The rest of the United States primarily knows Trump from his "The Apprentice" show and believe his act. Who knew that a candidate could make the most racist, misogynistic statements, deliver many flat out lies, attack reporters, veterans and the US president, yet rise continuously in the polls?
On the Democratic side, we commented last summer that "to win the nomination, Clinton would have to put the private e-mail server and Benghazi behind her." Bernie Sander took care of the first issue in October's debate when he declared, ""The American people are sick and tired of hearing about your damn emails. Let's talk about the real issues facing America!" Two weeks later, she faced down a clearly partisan Benghazi commission in 11 hours of grueling testimony. By that point Vice President Joe Biden had announced he would not run for president. Clinton's polls, which suffered through the summer, resumed an upward trajectory. Given Clinton organizational and financial resources, only a terrible accident or ill health will block her from the nomination.
Primaries start February 1st in Iowa with 33 states completing elections in February and March. We don't know who the Republican nominee will be now, and there's a chance we won't know until the Republican convention in July 18-21.
The Electoral College decides the US Presidential election. We know even now that New York and California will vote Democratic, Texas and Georgia will vote Republican. We can reasonably forecast that the Democratic nominee has 256 votes locked up versus 206 to the Republican candidate (270 to win.) Only these states - Colorado, Florida, Iowa, Nevada, New Hampshire, Ohio, and Virginia - are reasonably in play, and all these states were won by Barrack Obama in 2012. The grand prize is Florida - as we saw in 2000, the party that wins Florida wins the election. So it would not surprise us if Rubio ended up as the nominee. However, to gain 270, the Republicans also must win Ohio (Kasich for VP?), Virginia, and either New Hampshire, Nevada, Iowa or Colorado. If the Democrats win Florida or Ohio, or Virginia and any other state, the election goes to the Democrats. Buckle up for a brutal ten months.
Bill Cosby - serial rapist? Can we trust anyone anymore?
As things are now, so shall they not be a year from now - better or worse, but not the same
People reflexively project current short term trends to infinity. A client recently asked us, "how could he retire if investment returns continued at low levels." Our answer is that "one year in four will produce poor investment returns in US stocks, but gains in the other three years result in long term positive returns. Short of atomic war, meteor strike or world-wide zombie apocalypse, we can be confident that investment returns will enable us to pay out a client's retirement draw for the rest of their life."
The world economy is going through a slow patch right now, depressing revenues and earnings for US companies (60% derived from international operations.) Economists often refer to the US as the "locomotive of global growth." With an improving labor market, firming wage growth, low inflation and still-low interest rates, sustained consumer spending will keep the US economy growing at least 2.5%/year, and in so doing bring along the rest of the planet. US stocks are just 4.25% off the record set in May 2015. We have no doubt new records will be set this year.