More of the Same
Equity Investment Outlook
During 2014 the U.S. economy gained steam as the year went on and delivered some of the strongest growth numbers in more than a decade. Surprisingly, as this occurred, inflation indicators barely budged and interest rates declined. A 50% collapse in the price of oil and weakness in other commodities helped keep inflation low, while challenging economic conditions outside of the U.S. supported low interest rates. The great debate in the investment community in early 2015 is whether the collapse in commodities is foretelling the next global recession and, if so, whether the U.S. economy could be pulled down with it. We think a recession is unlikely either globally or in the U.S. in the next 12-24 months. We admit to a certain level of discomfort watching economic conditions deteriorate in our major trading partners Europe, Japan and China, but ultimately we believe lower oil prices, low interest rates and stimulus-centered bank policies around the world can keep the global economy out of recession.
Outside the U.S., economic conditions appeared to deteriorate over the course of 2014. The eurozone was plagued with deflationary forces and persistently weak economic conditions. China’s growth slowed significantly from a 10%+ annual rate over the past decade to less than half that, currently (based on some non-governmental estimates). Japan dropped back into outright recession. The slowdown in these major economies led to very weak commodity prices. Not only was oil down, but copper and other commodities hit new multi-year lows. Export-oriented economies, such as Brazil, Australia, and Canada, are hurt worst by these lower prices.
Against a backdrop of improving U.S. growth and weak growth abroad, the U.S. stock market chalked up another solid year. The S&P 500 Index (“the S&P 500”) was up 13.7%. This strong aggregate return masked some rather stark divergences. For the year, the top 20 stocks (in performance impact) of the S&P 500 accounted for 41% of the index’s return, a fairly high percentage. For the second half of the year alone, the top 20 stocks accounted for a whopping 57% of the index’s return. In other words it was a very narrow market, which caused about 80% of all active managers – ourselves included – to underperform the index. Essentially, if you did not own the top 20 stocks, you could not keep up. This was very reminiscent of the mid- to late-1990’s when a small group of high-tech darlings accounted for an outsized share of the market’s gain.
We believe such a concentration of performance will reverse, collapsing under its own weight. In part this is because the S&P 500 is capitalization weighted, so those buying into the index have to buy more of the largest cap stocks, pushing the largest stocks further and further along the path towards overvaluation. This process feeds on itself until the overvaluation of the “winners” simply becomes too great. Eventually they can crack, dragging the index down sharply and allowing active managers who did not buy these stocks to outperform the index. We may be entering such a phase now.
Our economic outlook for the coming year is for a continuation of last year’s trends: moderate growth with low inflation in the U.S., struggles in euro-land and slow growth in emerging markets. Commodity prices generally may remain subdued, but we think oil is likely to bounce off its lows sometime later in the year. The current low oil prices should theoretically lead to a dramatic drop in drilling in the first half of the year, resulting in lower production growth in the second half. At the same time, consumers are likely to increase their oil consumption, thereby tightening the supply/demand balance enough for prices to rise. (For more on this subject see our client letter of December 2014.)
Historically, the biggest impact of lower oil prices is to enable U.S. consumers to spend more on other goods and services, thereby boosting overall economic activity. One economist recently estimated that if oil stays at $50 a barrel for the full year 2015, the economy would “save” about $200 billion or 1.1% of GDP. Of course, there would be some offsets due to economic weakness in oil-producing states. Overall though, we think consumer spending will rise in 2015 as a result of low oil prices and rising employment levels. Since the consumer represents some 70% of economic activity in this country, we think this means that one can be fairly optimistic about overall demand.
The juxtaposition of relatively healthy U.S. economic activity versus weakness in Europe and Japan, as well as slowing growth in China and other emerging markets, has led to a stronger U.S. dollar. This could act as a headwind for U.S. companies with extensive foreign sales and profits, as the strong dollar means such overseas profits translate into few dollar profits. All else being equal, this would suggest that more domestically-focused companies may prove better bets this year.
One of the biggest questions facing investors is whether U.S. stocks are cheap or expensive. In general, we don’t think stocks are cheap currently. We are six years into an economic recovery and while earnings are up 172% from the recession’s lows, stocks (as measured by the S&P 500) are up 244% from the bottom (as of 12/31/14). The current S&P 500 Price-to-Earnings ratio is 18x versus 16x on average for the past 50 years. But given the current low level of interest rates, stocks do not look overly expensive in our opinion. The classic way to value stocks is to discount (using an expected interest rate) the future stream of earnings or dividends, which is heavily dependent on the assumed growth rate of said earnings or dividends. The discount rate is usually approximated using a risk-free rate such as the return on a 10-year Treasury. Given the still-expanding nature of the U.S. economy, it is reasonable to project growth in corporate earnings and dividends. And given the low level of interest rates – and the likelihood of only modest increases in the years ahead – the discount rate should be quite low. The combination of growing earnings and dividends on the one hand and a low discount rate on the other hand could propel stocks higher, even from here. Whether, and to what degree, this happens is anybody’s guess. We are of the view that the conditions for further gains in the bull market that began in early 2009 are still intact and that the conditions for a true bear market are not. The market could, of course, be subject to corrections – it always is – but we believe the trend is still upward.
The key risks to our constructive view of the market are several-fold. First, global weakness could spill over into the U.S. The combination of a stronger dollar and weaker demand from our trading partners is likely to put pressure on U.S. exports and lead to higher imports. This would represent a partial offset to domestic growth drivers in coming quarters, but should not be enough to cancel the expected benefits of lower oil costs. Secondly, there is a risk that Greece and maybe one or two other countries may try to leave the euro, leading to potentially negative implications for banks holding Greek debt. The markets worry about the risks of some kind of financial contagion if this happens. Third, low oil prices are likely to cause financial strains in oil-exporting countries such as Russia, Venezuela and several Middle Eastern nations. Whether these strains will become serious enough to cause a financial crisis is an unquantifiable risk. History suggests that financial markets are likely to experience elevated but temporary volatility in the wake of such an abrupt change in the economic health of oil-producing countries. Fourth, there is a litany of potential geopolitical risks, from upheavals in China and flare-ups in the Middle East to a collapse in Russia that could upset the apple cart and cause the stock market to react negatively. It’s hard to predict such events and even harder to manage investments in the face of such consequential yet improbable events.
Another way to look at these risks is to lump them together and talk about a deflationary contagion, a period of weak prices and declining spending, particularly capital spending. The key investment risk in such a scenario would be persistent earnings disappointments, which in turn would lead to declining stock prices. While we regard this scenario as unlikely, the probability of its occurrence has increased and we are, therefore, monitoring the development of key components.
We remain focused on finding misunderstood companies with strong growth prospects, whose businesses are not overly dependent on macroeconomic or geopolitical outcomes. We think that in the current uncertain environment, the market may well pay a premium for growth. To the extent we can find growth masquerading as value, we will seek to capitalize on it.
We wish to thank all our clients for your trust in our management ability and for your loyalty over the years. We wish each and every one of you a healthy, prosperous and happy New Year.
John Osterweis Matt Berler
Past performance is no guarantee of future results.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Price-to-Earnings ratio is the ratio of the stock price to the trailing 12 months diluted EPS.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
This index reflects the reinvestment of dividends and/or interest income and is not available for investment.
Cash Flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
One cannot invest directly in an index. 
© Osterweis Investment Management