Friday, May 16, 2014

Financial Market Surprises for the Second Half of 2014

I have been thinking quite a bit about what is going to happen to the stock market in the remaining months of 2014. Below are four surprises that have a good chance of occurring in the coming months that are not currently widely reflected in common thinking.

Surprise #1

When Zacks Investment Management was a much smaller company we used to have our holiday parties around a table. Ben Zacks, my uncle and the other primary portfolio manager at Zacks, would go around the table and ask everyone which way they thought the market was headed. Based on whatever was happening in the market that month and the fact that people who worked at an asset management firm were being asked to state where the market was headed, most people wound up agreeing the market was heading in a given direction. Ben, after hearing everyone’s view would then pronounce that the market was headed in the other direction. The whole thing usually elicited a chuckle, but the exercise contained a very important lesson. When everyone believes the market is headed in a given direction that belief is reflected in market prices. As a result the market actually is more likely to head in the opposite direction.

Currently, there is a widespread belief throughout the media and individual investors that the market has come too far for too long. The crashes of ’08 and ’00 loom extremely large in investors’ minds and as a result while bullish sentiment is rising, it is not anywhere near the levels we usually see during a bull-market.

As a result most investors seem to see the market as overdue for a correction. I am not immune to the current zeitgeist. In my quarterly commentary for the first quarter of 2014 I also was looking for a pull-back or market correction. To some extent there is currently too much worry, too much concern about the stock market. Caution has not been thrown to the wind, as soon as speculative social media stocks rally they are immediately brought back down to earth. It is not the behavior we tend to see at the top of the bull market - cab drivers are not talking about owning Netflix ( NFLX ) stock and telling me I am crazy for preferring Johnson and Johnson ( JNJ ). Basically, too many people in the market are looking for a correction, there is some speculation but not what should be occurring after a five-year bull market.

Surprise: The Market does not pull-back over the next few months but instead the bull-market continues to climb the wall of worry.

Surprise #2

Economic growth in the first quarter of 2014 was very subdued. Much of the problem was based on the weather. The weather also helps explain why utilities as a sector did a little better than expected and retailers were under pressure. The natural state of the economy is expansion at a rate which is higher than population growth. Right now consensus expectations are for GDP growth just under 2% for the rest of 2014. I think it is possible for GDP growth to surprise to the upside. The reason is that there is likely to be a weather-payback.

In a healthy economy when the weather pulls back spending the spending does not disappear. The people who were going to engage in purchases and did not because of the weather just postpone the purchases until later. If someone was looking to buy a car in the first quarter of 2014 and they delayed their purchase because it was too cold and snowy to head to dealerships, they generally buy the car in the next quarter. As a result of the weather payback, it is very possible that just as GDP growth surprised to the downside in the first quarter it will surprise to the upside in the next few quarters. Additionally, employment seems to be firming and financial conditions are improving. Financial uncertainty is being reduced. All of this points to the possible surprise.

Surprise: The economy improves above trend due to weather payback, earnings of retailers surprise to the upside.

Surprise #3

There has been a huge push towards alternative assets by pension funds. I truly believe this push is wrong-headed. If all hedge funds were truly market neutral and bore no net equity exposure than for one hedge fund to generate returns another hedge fund would generate losses. There is only so much alpha to go around for a given hedge fund strategy. Essentially, hedge funds simply battle it out for this alpha. For instance, in risk arbitrage where a firm bets that an announced acquisition is going to close there is a limited number of announced acquisitions.

The alternative asset game is a zero-sum game. For some participants to win, others must lose. Long-only equity investing is not a zero-sum game because the pie – or aggregate returns of market participants can be positive across the board. The reason is that corporate earnings in aggregate generally grow over time and if P/E multiples remain relatively constant the stock market indexes head higher. It is very likely for every long-only equity investor to make money on average over the next ten years, it is impossible for every hedge fund to make money on average over the next ten years.

As a result of the market pull-back in ’08 the allocation to alternative assets increased dramatically. Large institutional investors became risk averse but they still needed returns, they turned to hedge funds. The timing as it often is with these things was completely off.

The alternative asset boom is likely to end not with a bang of hedge fund implosions but with the whimper of underperformance relative to the broad market. Interestingly enough Warren Buffet made a bet with a fund-of-funds that the S&P 500 would outperform a fund whose sole purpose in life is to pick other hedge funds to invest in. So far, Buffet is winning the bet.

Surprise: The institutional money in hedge funds continues to underperform the long-only market indexes. The towel begins to be thrown in later this year and the institutional money finds a new home being long the stock market.

Surprise #4

I have been calling for inflation for quite a long time. Yet, the ten-year yields started 2014 around 3% and now it is down to 2.6%. I believe that despite the pullback in quantitative easing the Fed’s bond buying is still making up huge chunk of the reason interest rates are going lower. It is looking more and more likely that quantitative easing is working better than most people anticipated. Despite the Fed pulling back on bond buying, interest rates have not shot up like they did in the late half of 2013.

I still expect that the Fed’s bond buying will be done by the second half of the year and anticipate inflation as measured by core consumer price inflation to rise from 1.2% in 2013 to 1.4% in 2014.

Government debts can only be repaid through raising taxes, cutting spending or inflating the currency. Common sense seems to indicate that the currency must be inflated to deal with the current budget debt. However, there is still an almost permanent increase in labor supply keeping wage inflation in check. Historically there has never been a period of price inflation without wage inflation. It is looking more and more likely that interest rates will not be rising.

Surprise: Inflation actually comes in lower than expectations. This causes interest rates to remain very low and allows fixed-income investments not to fall in value. As a result of lower than expected interest rates the P/E multiple of the market actually moves higher.

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