Bull Oak Newsletter – Cautious Optimism
Originally Published on 11/21/2014
Believe it or not, but we are witnessing history in the making. From the March 2009 lows, the 5 year and 9 month S&P 500 bull market rally has resulted in a 203% cumulative return!
S&P 500 Index – Yahoo Finance
Most that have participated in this historic run are a bit nervous about the risks to the market. Many professionals believe that this rally will continue. As long as U.S. company earnings continue to exceed expectations and the U.S. GDP growth rate continues to expand at an impressive rate (Q3 2014 U.S. GDP grew at 3.5%!), why shouldn’t it? While there is evidence to support this forecast, I am cautiously optimistic about the future.
There’s plenty to be enthusiastic about, no doubt about it. With cheaper oil prices (resulting in more disposable income), a stronger dollar, and the unemployment rate at 5.8%, what’s not to be excited about? Investors tend to have a very short memory. A bull market will not go on forever. There are plenty of concerns that we shouldn’t ignore. First and foremost, the market seems to be at the upper-end of a reasonable valuation. The S&P 500 TTM P/E is at 19.89 and the Russell 2000 TTM P/E is at 21.88. Neither index is cheap. I’m not stating that the market is overvalued, just fully valued. If the stock market continues to expand it’s earnings, then all is well. The keyword in all of this is “if.” I certainly don’t want to rain on anybody’s bull market parade, but there are very real risks to earnings growth out there. I know, I know…. you have to be willing to accept risk in order to reap the rewards. True enough, in most cases. However, one should not invest their capital with a blind eye to the realities of the world. Quantitative Easing (QE) is done, Japan is a mess, Europe is a bigger mess, and China is slowing down. In the global economy that we live in, I’m warily hopeful that U.S. companies can continue to grow their earnings at an impressive rate while decoupling their exposure from the weaker pockets around the world.
Let’s begin by imagining a world without QE. Consider the fact that this historic market rally was largely fueled by artificially low interest rates. The Fed’s QE program that forced interest rates to historic lows also forced volatility levels to historic lows. Any time that bad news hit the news wire, the Fed was there to prop up the skittish market. The 3rd and final round of the Fed’s $3T QE program officially concluded on October 31, 2014. The world’s largest economic experiment that began in late 2008 was, by most accounts, a huge success here in the United States. Without it, the world would’ve most likely entered into another Great Depression. However, the Fed is no longer here to offer a safety net. In short, volatility is back and it’s here to stay. The stock market’s performance is no longer supported by artificially suppressed interest rates, but rather, by it’s own merits. Keep in mind that the VIX is at historic lows. Since the 2011 Eurozone crisis, we have yet to see the VIX at a more normalized level, even with the October 2014 market scare.
VIX Index – Jan 2000 to November 2014 – Yahoo Finance
As it stand’s today, the United States economy is one of envy. We may have serious problems still to contend with (e.g. low employment participation rates, income inequality, burgeoning student debt, an aging population), but they are not nearly as severe as the problems the other developed countries are facing. Everybody knows that Japan and the Eurozone are facing very robust economic headwinds. With massive amounts of debt and little hope for a strong economic rebound, a positive outcome in both regions looks forlorn. Even if the BOJ and the ECB are able to successfully launch their own version of QE, that is only the monetary side of the equation. A cheaper Euro and Yen to the dollar will certainly help each region export their items. However, each region will still have to address their fiscal policies if they want to fix their massive debt woes. While each country would prefer to grow their way out of their debt, at this point, I don’t think it is a realistic strategy. Remember, Europe is the largest economy in the world and Japan is the 4th largest. A slowdown in either region will have a large global economic impact.
Europe’s biggest problem is that each nation operates fiscally independently from each other. While the region operates under a single monetary union (the Euro), it does not operate under a fiscal union as the U.S. does. Due to it’s economic and cultural differences, I do not believe that there will ever be a fiscal union in the region. As a result, the ECB is very limited to what it can provide to the region. Even with Friday’s news from Draghi that the ECB is willing to broaden the pace, size, and composition of asset purchases, it is only a temporary fix. For the time being, it is encouraging news that will help lift global equities. However, it does not solve the larger issue of too much debt and too little production. Unless something dramatic happens, I believe that a slow and painful economic slide will continue to weigh in the region.
China also announced today that it will lower its one-year lending rate and it’s one-year deposit rate in an attempt to stimulate it’s economy. On the heels of that news, Asian equities rallied. This is expected as China’s economic growth has been on a steady decline since 2007, with a 2014 forecast rate of 7.5%.
GDP Annual Growth Rates – World Bank
China’s biggest concerns are the slowing demand for raw materials, a slumping housing market, and sluggish retail sales. Motivated by the slowdown, Beijing’s leaders were prompted to take measures that would help spur faster economy growth. While economic growth is expected to continue to slow over the long-term, recent moves by Beijing show China’s willingness to open it’s economic doors to help temper that slowdown. Beijing has to be careful how they approach this downtrend. If they do too little, they run the risk of producing higher unemployment and business bankruptcies. If they do too much, they run the risk of creating a real estate and/or a debt bubble.
In this current market environment, one cannot afford to be either too optimistic or pessimistic. The U.S. equity market is clearly the asset-of-choice and capital is certainly going to continue to flow here. However, the U.S. stock market is no longer cheap. Additionally, there are very real problems in the world and these problems can be expected to impact the Unites States. Nobody knows when, if, or how this can happen. Sitting on the sidelines can be very costly, though, especially for those individuals that cannot afford not to invest. The prudent choice is to invest cautiously. Quantitative Easing, of some sort, should be expected out of Europe and Japan and more easing should be expected out of China. However, nobody knows how effective these measures will be. Be careful how you are invested and be sure not to over-exposure your portfolio to areas of weakness.
Remember, a rising tide lifts all boats only when everybody has a boat. Don’t be the one left at the dock. However, also be sure that your boat can handle the economic headwinds on the horizon.
Ryan Hughes, Founder & Portfolio Manager, Bull Oak Capital, Bull Oak Newsletter – 11/21/2014
While the information presented herein is believed to be accurate, Bull Oak Capital LLC (Bull Oak) makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Bull Oak is under no obligation to notify you of any errors discovered later or of any subsequent changes in opinions. Nothing herein should be construed as a recommendation to buy or sell any of these securities. It should not be assumed that any of the securities, transactions, or holdings discussed will prove to be profitable in the future or that investment recommendations or decisions Bull Oak makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Bull Oak or its employees may have an economic interest in securities mentioned herein. This information is intended only for the recipient of this email. Under no circumstances should this report be shared with or forwarded to anyone else without the express permission of Bull Oak.