It’s that time of year again, and many of you have asked us what 2015 is likely to bring in the way of economic performance and the market’s likely response to it. The following is based on my usual exhaustive reading, and I encourage you to follow through the many hyperlinks within the piece for the sources of the summaries shared below.
The S&P 500 is up over 205% since the market bottom on March 9th 2009, largely due to heroic Federal Reserve intervention, averaging growth of 35% per year for 5 years and 10 months. Market history since 1929 is hardly that robust, averaging 8.3% annual growth. This means that US stocks have been on a Fed-led tear of four times normal growth for nearly 6 years, while the average bull market has lasted 3.7 years. Only two other bull markets in US history have lasted longer—and the average decline of a typical bear market has been -34% historically.
Finally, Professor Robert Shiller’s cyclically adjusted price earnings ratio (Shiller CAPE) for the S&P 500 is currently at 27.2, some 64% above the historic aver-age of 16.6. On only three occasions since 1882 has it been higher—in 1929, 2000 and 2007—right before the markets crashed thereafter. As John Templeton famously stated, “bull markets mature amid optimism and die in euphoria.” He then added, “The four most dangerous words in investing are ‘This time is different.’”
The Federal Reserve, the primary author of these gains is now on the sidelines having ended their asset purchases at the end of October. After QEs 1-3, the Fed’s credibility is dependent on the narrative that the economy can now stand on its own. Were that assertion to come into question and cause the Fed to once again come to the economy’s aide, the Fed would appear to have over-sold us on their omniscience, bringing their credibility into question and causing markets to lose confidence.
As one analyst put it after the last FOMC meeting, “…the Fed is not riding to the rescue with liquidity this time around. Energy stocks are now on their own and markets will be left to decide how things play out from here.” Adam Hamilton agrees, writing that “…the Fed has abandoned the stock markets. …With QE3’s new buying terminated and any QE4 a political impossibility with the new Republican Congress, 2015 is going to look vastly different. A shrinking Fed balance sheet sparked major corrections even from far lower and cheaper stock levels. …(T)he serious gravity of the Fed’s absence will become readily apparent once the next selloff starts cascading.”
While the U.S. economy is showing a cautiously optimistic return to below-normal growth, most of the rest of the world is teetering on recession or is well into stagflation. Europe is sliding into recession as its powerhouse economy, Germany, rather than slowing the decline of the peripheral economies (Greece, Portugal, Spain, Italy), seems to be leading the way into the abyss. German GDP was +0.1% in the second quarter of 2014 and -0.1% in the third quarter, an average of zero growth.
Europe is not alone. Russia is struggling with the twin crises of dropping oil prices and the rapid devaluation of the Russian ruble, causing their stock market to decline over -60% since July. Venezuela, Ukraine, Iran, and Nigeria are also buckling under the weight of falling oil prices. China’s export economy has been widely reported to have been cut in half, and in a piece entitled, “Japan Economy Falls Into Surprise Recession”, Marketwatch reported last month that “Japan’s real GDP shrank -1.6%.. None of the 18 economists surveyed by The Wall Street Journal had forecast a contraction; the median forecast was for a +2.25% expansion.” The figure marked the second quarter of contraction, after the economy shrank -7.3% in the April-June quarter. Note that 18 out of 18 economists got it wrong, off by an astonishing 3.85%, not the usual half a percent, something that should raise eyebrows among the investor class that too often depends on such forecasts.
So what does this mean for U.S. markets? Will the global flight to safety bring additional capital to our bonds and equities, as foreign investors prefer our “least worst” markets to their own—or will the growing global recession drag U.S. markets down with it? As Guggenheim Partners’ Scott Minerd put it, “…The events overseas provide ominous portents of things to come. If we do get a sign of a bear market in U.S. equities, it could be that the events in Europe presage what lies ahead for the United States. Is it too late to change these shadows of dark foreboding? It is hard to tell but time is not on our side.” Whatever you decide, only the bull markets that ended in 1929 and 2000 lasted longer than this Fed-engineered bull—right before they ended really badly.
The Euro Crisis is back and worse than ever, (at the same impasse and even more in debt) and The Unthinkable—a Greek exit from the common currency after defaulting on its loan obligations—is now being called “manageable” by the Germans at the ECB and Bundesbank. Greek voters appear likely to vote in the far-left Syriza party later this month, a party that has run on a platform of rejecting the austerity 
measures and strict fiscal discipline being demanded of it by the countries from whom they borrowed billions to continue their profligate ways. As one analyst predicts, Greece will repudiate its debt, the ECB will then cut off funding to the Greek banks “at which point the only possibility for Greece is to bring back the drachma to recapitalize those banks and keep the economy open.” After a painful crash of the Greek economy, Greece would eventually survive, inflating their way out of the mess they’re in, certainly nothing worse than the depression they’re now in anyway. At that point they become the role model for a successful exit that two far larger economies, Italy and France, also “teetering on the edge of public debt spirals”, need to do the same. “If Greece did leave and then bounce, there would be discrete preparations in both countries for the abandonment of the euro…”
To fully appreciate the upheaval this would cause, one need only realize the scale of daily currency trading worldwide: While all of the world’s equity markets combined constitute about $300 billion in daily trading, world currency markets trade over $4 trillion daily, thirteen times as much. Surely the piecemeal abandonment of the world’s second major currency would bring about fear and disorder on a scale many times that of the events of 2008. Don’t think this can happen? Just look at the size of the nationalist and anti-austerity protests now taking place across Europe, and the level of discontent and anger at the central government in Brussels.
The price of oil is down an astonishing 49% in the last 6 months, with Wall St. bulls pointing out that much of the economy will benefit from the trickle-down effects of cheaper gas and lower production costs. What they overlook is that 1/6th of our economy is now in extreme contraction and approaching recession, as the energy sector begins lay-offs and huge reductions in capital expenditures. U.S. and multinational firms with a large presence here are already laying off rig workers and the bankruptcies of highly-leveraged producers in the shale patch are imminent.
As firms spend less on development and downsize their work forces, foreclosures and other debt defaults will impact the economy even in support sectors (shipping, housing, refining, piping, chemicals, transportation, even food service) around the oil patch. Texas, which lead the nation in job creation these last 5 years, has been hit especially hard, as have Louisiana, North Dakota, Oklahoma, Alaska and others. Many S&P 500 firms have direct ties to oil, and for many others the energy sector is their largest market with the best-paying jobs. With Global Recession imminent and widespread, the US cannot remain the world’s lone holdout with 16% of our economy in recession and another 15-20% adversely affected.
Economically, affordable gas is little to celebrate when we’re losing thousands of high-paying jobs, and the homes of the recently unemployed will soon be in foreclosure. Analysts estimate the overall drop in US GDP as high as -2.6% “Those expecting a lot of help for the US economy from low oil prices seem likely to be sorely disappointed. Certain industries may be helped; but overall the damage to the price structure and oil industries will be too dramatic not to be harmful to the US economy. …It could be a time of injury to the markets; or it could be a time of dramatic injury to the markets. Only time will tell.”
Recent revisions to 3rd quarter gross domestic product (GDP), i.e. the pace of growth in the economy, came in at 5%, much to the delight of Wall Street and the administration. Looking inside the numbers, however, we see one-offs in manufacturers’ new orders of durable goods, most of which occurred in July. As economist John Early stated in this brilliant piece, “July was a blowout month for orders; at an annual rate it was up 147% from the prior quarter. This made for the strongest growth of durable goods for any quarter since the data series began in 1992. …Q3 was strong, but it likely robbed growth from Q4.”
In other words, the seemingly strong third quarter 5% GDP number reported by the government was an anomaly, and we’ll know by the end of January the degree to which it was overstated. Early predicts GDP will grow only 0.1% in the fourth quarter, and adds, “Five out of seven factors in our GDP model point to lower growth in 4th quarter. Two of them point to the weakest growth since 2009. He goes on to predict that “2014 will probably finish with a growth rate near 2.2%, the 4th year in a row growth has been weaker than 2.4% and the ninth year it is under 2.7%. …The 5% Q3 growth does not mean the economy is strong or that it is accelerating. …Corporate earnings announcements starting in January should reflect economic weakness. Job growth which lags GDP should weaken sometime in early 2015. The shattered perception of an accelerating economy will make the trade weighted dollar index and stock market more vulnerable to sharp corrections. …(W)ith growth running at a low 2% rate, the economy could dip into recession at any time.
The seventh and final reason not to trust the stock market this year is that even the optimists don’t trust it (much). Goldman Sachs, Barclay’s, and Credit Suisse just released their analysts’ forecast for where they believe the S&P 500 will finish 2015. Their unanimous consensus? A whopping gain of only 4.3% for the year, hardly worth risking the 205% gain of the last 5 years and 10 months over. How many people do you know who, ahead of the casino by 205%, would bet those gains on only a 4.3% upside on the next hand—when their probable downside loss is -34%? That is precisely the average decline of the typical bear market since 1929—the average. The last two were declines of -51% and -57%.
In summary, 2015 may be the year wherein simply being the “least ugly” markets in the world may no longer be enough to attract investors for the long term. Expect plenty of volatility, crashing commodities, currency wars, geopolitical challenges galore, and an investor class who may soon decide that their gains of the last 5.8 years simply aren’t worth risking, and that the sideline is looking more and more like a good place to rest. After all, if you’ve already won the game, why are you still out on the field?
Breathe easy, and spread the word.
Thomas K. Brueckner
President & Chief Executive Officer
