2015 Economic & Stock Market Outlook December 9, 2014

Transcription

1 Baird Market & Investment Strategy 2015 Economic & Stock Market Outlook December 9, 2014 Please refer to Appendix Important Disclosures. Weight of the Evidence Points North Outlook Summary Economy continues to re-accelerate growth in 2015 could approach 3.0% Secular progress would be evident in improving trends for Middle Class Stock performance in line with historical patterns could mean 2400 for the S&P 500 in 2015 Elevated valuations and a lack of investor liquidity represent the primary risks for stocks Dollar strength, commodity weakness, and global uncertainty could keep the Fed friendly Bonds likely to surprise consensus with yields staying lower for longer than expected. 10-year T-Note range for 2015 between 2.25% and 3.00% Highlights: Fed Has Moved to Sidelines, but Tightening Regime May Not Emerge in 2015 Maligned Middle Class Could Get Economic Relief at Gas Pump Valuations Suggest Stocks Overbought Relative to Fundamentals Lack of Investor Liquidity Could Make for a Bumpy Ride Seasonal Tailwinds Blowing Strongly in 2015 Breadth Improving but Has Yet to Send All-Clear Signal The investment horizon, in theory, is basically infinite, but for any of us it could unexpectedly be reached today. By convention we break it into yearly chunks for discussion and digestion. A year ago we described 2014 as a year of transition, one in which the thesis of secular progress would be tested. And now, on the cusp of a new year with new opportunities the outlook for the economy and stocks appears to be getting better. We continue to build on the progress made in recent years. This is not to say that 2015 will not have its stumbles or challenges. Rather it is a reminder that when the stumbles and challenges do inevitably crop up, they should be viewed in the context of an improving secular backdrop. Challenges offer opportunity for the agile and wellprepared. Investors who continue to nurse the view that a relapse into crisis is not only inevitable but imminent hold an increasingly untenable view that is unsupported by the weight of the evidence. Bruce Bittles Chief Investment Strategist bbittles@rwbaird.com William Delwiche, CMT, CFA Investment Strategist wdelwiche@rwbaird.com R.17

2 Secular stagnation became the phrase du jour in 2014 to describe the global economy. Under this scenario, growth rates might be permanently subpar, with demographic and debt trends crippling growth prospects. This seems more reflective, in our view, of what we have experienced in recent years than what might be in store for the U.S. economy. Using the rear-view mirror to forecast the future has been singularly unsuccessful. Over the past 15 years, actual economic growth has consistently fallen short of forecasts. But in secular expansions, forecasts miss in the other direction. From 1982 to 2000, actual growth consistently exceeded forecasts. Evidence that a secular turn has been made would be that actual growth begins to exceed expectations. And widespread discussions of secular stagnation, and the resulting forecasts, provide a good set up for this scenario. There remain serious and significant headwinds in the US and global economies - we would not argue otherwise. Debt levels continue to stretch to new heights and demographic trends remain headwinds (thus the affinity for discussions of secular stagnation). The middle class has seen such little progress that many view the recession as ongoing. Geo-political tensions abroad and political uncertainties domestically seem perpetually poised to upset the apple cart. But these are not new and unknown issues. They flare-up and then subside. There is little evidence right now that the pattern will change in In fact, despite flare ups and uncertainties in 2014, stocks rallied throughout the year and pullbacks were limited in both degree and duration. That alone is strong evidence that a secular shift has been seen. Economic growth appears to be on an upswing. Over the past two quarters of available data (Q2 and Q3 of 2014), Real GDP has advanced at its best pace in a decade. The labor market continues its slow recovery and the middle class, squeezed by a persistent decline in real household income in recent years, could finally get some relief in the form of lower prices at the gas pump. While growth is showing signs of accelerating, inflation remains muted and is anchored domestically by deflationary winds that are blowing overseas. While improving economic fundamentals are a positive for stocks, they are not the sole input used to derive our outlook. Even in periods of strong or improving growth, stocks can falter. The lesson to 10% 8% 6% Real Gross Domestic Product (GDP) We've just seen the best six months of GDP growth in a decade 4% 2% 0% 2% 4% 6% 8% 10% Recession Quarterly Growth 2 Quarter Growth Source: BEA Robert W. Baird & Co. Page 2 of 8

3 remember is The S&P 500 suffered a nearly 20% correction in the third quarter of that year while GDP growth remained strong. The weakest quarter of the year from a growth perspective was the second quarter, when GDP was up 3.9% (annualized). For the year, GDP was up 5.0%. Stocks recovered later in 1998, with the S&P 500 finishing the year at an all-time high (and up over 30% from where it began the year). The long-term correlation between the health of the economy and strength in the stock market is sufficiently variable over shorter time periods as to frustrate even the most stalwart long-term investor. We do not necessarily expect to see a 20% decline in 2015, but that does not mean one will not emerge. Using economic fundamentals as a sole input for stocks can, and does, lead to missteps. In the words of British economist J.M. Keynes, the market can stay irrational longer than you can stay solvent. An undue focus on being proven right in theory can produce sub-par investment returns in reality. This is not an argument against developing expectations, but rather, a reminder to build into the investment process a means of testing those expectations against reality. Weight of the Evidence Within a suite of indicators considering economic fundamentals can help gauge opportunity and manage risks. Fundamental indicators overall are great at identifying risks and opportunities over the longer term. Their relationship with stock prices over the shorter term can be varied and at times seemingly non-existent. Technical indicators keep us in harmony with the direction of stocks prices and current crowd psychology. They also tend to be reactive and can send conflicting signals. We rely on a suite of indicators, because managing risk is also about not being misled by a single indicator that has gone bad. Federal Reserve Policy is bullish. The ending of domestic quantitative easing has led to an immediate discussion about how soon the Fed will start to raise interest rates. FOMC statements and speeches by Fed officials are dissected for attempts to glean some marginal change in views and policy. While an entertaining pursuit for some, recent history has shown the market (and Fed officials themselves) has consistently overanticipated the pace of tightening. We do not see this changing in Market expectations are that the Fed will start to raise interest rates Source: Ned Davis Research Robert W. Baird & Co. Page 3 of 8

4 (perhaps couched in language of normalization not tightening ) sometime toward the middle of the year. Given the current backdrop, our view is that the Fed is unlikely to raise interest rates any time in While the unemployment rate has come down, broader measures of the health of the labor market offer a more cautious picture. But this is only half of the Fed s mandate. The continued lack of wage growth, drop in energy prices, and the rise of deflationary pressures in Europe and other developed markets provides the Fed with ample opportunity to be patient. Two factors typically compel the Fed to raise rates: dollar weakness and rising inflation pressures. Neither is present now, and neither appears to be on the horizon for This could keep the Fed on the sidelines longer than many expect, again. Economic Fundamentals are bullish. Even before the drop in oil prices seen in the second half of 2014, the economy appeared to be gaining traction and inflation pressures were benign. In addition to keeping overall inflation low, the drop in oil prices acts as tax cut for the hardhit and still lagging middle-class. In fact, lower oil prices, and the relief it provides at the pump, has the greatest impact on those around the median income level those who have seen household income not only stagnate in recent years, but actually move lower on a real basis. Whether the upswing in growth seen since mid-2014 can be sustained remains an uncertainty, but unlike previous episodes during this recovery, the better news in 2014 has lasted for more than just one quarter. A shift into second gear by the economy may be what is needed to finally provide some relief and better conditions for the struggling middle class. It should be noted, however, that much of what ails the middle class can be described as secular in nature, residue of poor policies and decisions from the past. Lower prices at the pump provide some relief and the ongoing energy renaissance overall is a tailwind, but the welldocumented skills gap and the continued accumulation of excessive levels of debt are not easily solved. The path is likely to be higher for the economy in Relative to the recent past growth may well have improved, but we are still unlikely to see sustained growth above historical averages. Source: Ned Davis Research Robert W. Baird & Co. Page 4 of 8

5 Valuations remain bearish, and coupled with an overall lack of liquidity, represent a primary risk for stocks in When viewed from a long-term perspective, the economic fundamentals describe the trend, while valuations represent variation around that trend. To this extent, valuations are similar to overbought/oversold indicators. Elevated valuations reflect a price rally that has become overbought relative to economic fundamentals. From a risk perspective, however, this is somewhat mitigated by the improving underlying trends in the economy. Overbought conditions within up-trends can persist and when they get resolved it might be through consolidation rather than correction. Likewise, elevated valuations within the context of improving fundamentals can be resolved through continued appreciation in earnings (or whatever it is that price is being compared to). While the valuation picture is bearish, and current valuation levels are consistent with sub-par forward returns, improving fundamentals suggest valuation relief could come from better earnings growth, not necessarily just price correction. Sentiment is neutral, but the rise in optimism in the shorter-term surveys suggests the late rally has become too popular. A rebuilding of skepticism in early 2015 may be needed to support the next leg higher in the bull market. Household allocations to stocks are moving toward peak levels seen in 2000 and This means less liquidity in terms of un-invested cash. Investor liquidity acts like shock absorbers do for a car. Ample liquidity helps absorb the bounces and pot holes that are in the path forward. When shock absorbers get old and worn out (when investors become illiquid, as is now the case), the ride can get much bumpier and the risk of a pot hole sending the car into a ditch increases. Just as bad shocks are not readily apparent when driving on a smooth road, the effects of illiquidity are not easily discerned when stock prices are rising. But that does not mean the risk has gone away. Offsetting this elevated exposure to equities and the optimism it suggests, is a still-strong reflex on the part of investors to filter news through the lens of 2008/09. This can be seen in the surge on bearish sentiment that quickly emerges when stocks turn lower. Even normally bullish events (like the drop in the price of oil) quickly get cast in a negative light. Underlying this Source: Ned Davis Research Robert W. Baird & Co. Page 5 of 8

6 skepticism may be a lack of confidence about the overall economy. In recent years, cautiousness on Main Street has offset optimism on Wall Street. If the economy continues to improve in 2015, this ballast may be removed, leaving stocks more vulnerable to excessive investor optimism and the accompanying lack of liquidity. So far, however, that is not the case. Seasonal Patterns & Trends provide a powerful bullish tailwind for stocks in did not experience the overall weakness into mid-term elections that history suggested was likely, although the relationship between small-caps and large-caps in 2014 held true to its seasonal pattern. Seasonal patterns, however, are not about making fixed forecasts for returns, but as with much of our work, are useful in identifying risks and opportunities. From a seasonal pattern perspective, 2015 is about opportunity, and this opportunity has already arrived. The final quarter of the mid-term election year and the first two quarters of the third (Pre- Election) year of a presidential term represent the strongest three quarters of the entire 16-quarter presidential term. The third year of the four-year presidential cycle has been up in each of the past 11 cycles. Over the past 20 cycles, from the midterm election low to the pre-election year high, the S&P 500 has seen an average rally of nearly 50% not only has its status as a pre-election year working in its favor, but it is also a year ending in 5. Years ending in 5 have not been down in more than 100 years, and have posted an average return of around 20%. They have been, by far, the best years of the decade in which to own stocks. Importantly, these seasonal patterns do not emerge in a vacuum. The pre-mid-term election period in 2014 did not see as significant a drawdown as might have been expected. The weakness was still sufficient to turn short-term sentiment excessively pessimistic, allowing for a sharp rally. Momentum surged as stocks rallied, and the up-trend that looked to be stalling over the course of 2014 was instilled with new life. With stocks having gotten back in gear, the powerful seasonal tailwinds for 2015 have a better chance of filling the market s sails. Breadth is neutral heading into Whereas most of 2014 saw breadth deteriorating, moving from bullish to neutral to bearish, the final quarter of the year has seen that trend reverse. The momentum that emerged off of the October low showed itself also in our breadth indicators. Most 200% 180% 160% 140% 120% 100% 80% 60% S&P 500 and Industry Group Breadth Breadth gains have slowed, but its still heading in the right direction: 81% of groups across capitalization levels now in uptrends % Industry Group Up Trend % 20% S&P 500 (right) 0% Source: FactSet, RWB Calculations Robert W. Baird & Co. Page 6 of 8

7 notably, the percentage of stocks trading above their 200-day averages surged from a multi-year low of 30% to 70% by December (readings above 65% are typically evidence of bullish strength in the broad market). Likewise, the percentage of industry groups in up-trends, after making a series of lower highs and lower lows earlier in 2014, broke out to the upside later in We continue to score breadth as neutral for now, but at least it is heading in the right direction. Missing from the breadth gains seen in late 2014 has been a wide spread expansion in the number of issues making new highs. In fact, indicators based on new highs and new lows at the issue level have actually flashed bearish signals. To some extent this has been a reflection of small-cap underperformance for most of the year and reflects corrections seen in the average stock. While the NASDAQ Composite overall is on the cusp of breaking 5000 and is trading at levels not seen in over a decade, nearly half the stocks on the exchange were still 20% (or more) below their 52- week highs as of December. While breadth is heading in the right direction, it has not yet provided an all-clear signal. We will continue to watch closely to see confirmation that the gains witnessed toward the end of 2014 continue to expand. A new high in the small-cap Russell 2000 would be strong evidence that breadth is turning bullish. Key Investment Themes for 2015 What (and Where) We Are Watching With the weight of the evidence bullish as we make the turn toward 2015, we offer three themes that have come into focus. One is a trend that is expected to continue, the other two are opportunities that could be on the cusp of emerging. United States leadership expected to persist. The United States remains in a multi-year up-trend relative to the rest of the world, a trend that strengthened over the course of While the U.S. Fed has backed away from quantitative easing, central banks overseas are now being compelled to pursue extraordinary monetary policy measures. The divergence in central bank policy has fueled strength in the U.S. dollar. The underlying economic weakness that is compelling these actions has helped keep a lid on inflation, and as a result, U.S. Treasury yields have remained low. The combination of U.S. dollar and bond strength is a powerful tailwind for U.S. leadership relative to the rest of the world, arguing that a well-established trend will remain intact. Small-caps have rally opportunity. We have not yet seen strong evidence that small-caps are gaining the upper-hand relative to large-caps. Conditions are ripe, however, for their leadership. The dollar and bond trends that support U.S. stocks versus their international counterparts also support strength in small-caps versus large-caps. On top of that, the powerful seasonal patterns that support stocks in 2015 also favor small-caps versus largecaps, especially into the middle of the year. We saw hints of small-cap leadership during the late-2014 pullback, but relative follow through has been lacking. We will be watching our industry group rankings for continued evidence that small-caps are gaining strength relative to their large-cap counterparts. Energy renaissance goes global, helping emerging markets re-emerge. We have identified the United States as the hot new emerging market in recent years, believing that the energy renaissance was a game-changing process that provided us with an advantage over the rest of the world could be the year that more conventional emerging markets make a comeback. The late-2014 collapse in the price of oil expands the energy renaissance benefits onto the global stage. The primary beneficiaries may be oilconsuming emerging markets. While the international developed markets could struggle in 2015, growth in emerging markets appears to have stabilized, and could now get a boost from lower energy costs. While we recommend an overall equity mix that is tilted away from international exposure and toward U.S. exposure, within the international component, we expect emerging markets to build on the work seen in 2014 and move definitively into a leadership position. Robert W. Baird & Co. Page 7 of 8

8 Appendix Important Disclosures and Analyst Certification This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST The indices used in this report to measure and report performance of various sectors of the market are unmanaged and direct investment in indices is not available. Baird is exempt from the requirement to hold an Australian financial services license. Baird is regulated by the United States Securities and Exchange Commission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australian laws. This report has been prepared in accordance with the laws and regulations governing United States broker-dealers and not Australian laws. Copyright 2014 Robert W. Baird & Co. Incorporated Other Disclosures UK disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W Baird Limited holds an ISD passport. This report is for distribution into the United Kingdom only to persons who fall within Article 19 or Article 49(2) of the Financial Services and Markets Act 2000 (financial promotion) order 2001 being persons who are investment professionals and may not be distributed to private clients. Issued in the United Kingdom by Robert W. Baird Limited, which has an office at Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB, and is a company authorized and regulated by the Financial Conduct Authority. For the purposes of the Financial Conduct Authority requirements, this investment research report is classified as objective. Robert W Baird Limited ("RWBL") is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the Financial Conduct Authority ("FCA") under UK laws and those laws may differ from Australian laws. This document has been prepared in accordance with FCA requirements and not Australian laws. Robert W. Baird & Co. Page 8 of 8