Despite worries about Greece and the southern Eurozone countries in general, the Ukraine crisis, Ebola, ISIS, and decelerated growth in the emerging markets, the US and European stock markets ended 2014 with significant positive returns. 11% and 7% are not even half the returns of the former year but still acceptable, especially considering that both markets had already doubled since 2009. How do we arrive at the idea that 2014 was like 2008?
There are two parallels. Looking under the hood of the broad market indices, you see the stronger performance of defensive sectors compared to their offensive peers. In the US as well as in Europe, this remarkable outperformance was last observed in 2011 and 2008. We remember that in 2011 the US rating downgrade lead to a negative return in Europe, while the US markets managed to finish flat. There is no need to elaborate on 2008.
Another indication for the dominance of a defensive positioning in 2014 is given with a simple strategy that we introduced in our brief study “Embrace the next Stock Market Drawdown”. According to this strategy an investor sits on the sideline to wait for a drawdown just to jump into the US equity market for one month. In the last year, two major drawdowns occurred. The return of the strategy would have been close the S&P 500 return with a holding period of only two months and a maximum potential loss of -0.7%.
The second parallel with 2008 is the falling oil price. One might think that the outperformance of defensive sectors is a consequence of the strong depreciation of oil. The downward trend started last summer, at a time when defensive sectors, especially health care and utilities already had the best year to date performance (on a level with energy stocks, by the way).
After 2008 and 2011, two years with returns in the region of 20% on average followed. Will we see this happen again in 2015 and 2016?
If you look back further into the past, the last time defensive sectors exhibited such an outperformance against offensive ones was 2000. It was the first of three years of lower stock prices after the dot-com-bubble had burst. Back then, it would have been wise to stay invested in the more defensive sectors. It would have been even better to have no exposure to the equity markets at all. Whether we believe 2015 will look more like 2001 or will be closer to 2009, is outlined later in the text.
Beyond similarities with 2008, 2014 was an interesting year from other perspectives. We entered new ground in the bond space. Yields can move lower than expected and still attract investors. The yield is not only extremely low in liquid government or corporate bonds, but even in less liquid asset classes like commercial real estate levels have not been seen before.
Our Strategies in 2014
Our Multi-Strategy Global Equity approach which combines a market overlay with several single strategies on global equity markets, reached 44 new highs. We point out this ability because two major drawdowns shaped the past year. Other approaches which incorporate a protection against drawdowns often miss to re-enter the market fast enough. Reaching new highs takes longer. As we prevented this pitfall of classic trend-following, the Multi-Strategy Global Equity approach finished 2014 just 1% below its high established in November.
Only three out of the seven single strategies currently implemented could outperform the S&P 500 in the past year. US index rotation is among those three. The NASDAQ 100 was selected over the S&P 500 and the Russell 2000 nearly all year long. The Emerging Market selection also had a nice outcome. India was selected for all 12 months while China and Brazil shared the second spot over the year. Russia and Mexico were ignored.
By far the best strategy was the European sector selection. In each month of 2014 it managed to outperform its stock market universe. In contrast, the US sector selection which is based on a different research approach had not a good year. The oil price decrease with its negative consequences for energy stocks was mainly responsible for a return only slightly above zero.
Between the two extremes lie the European index rotation and the US style rotation. Both strategies exhibited a number of position changes, often a bad sign.
In summary, the majority of strategies did not have a good year but the combination within the Multi-Strategy approach was convincing. Diversification across regions, risk-return drivers and market granularity (index, sector, style) met the objectives of our investment philosophy. Neither a single strategy nor the combination relies on correlation figures or on “safe bets”. We remain protected against false safety that leads to such ugly surprises like the Swiss Franc movement seen last week.
Outlook
Europe’s QE, the new bond-buying program of the ECB, is highly anticipated. Therefore, the interest rate environment will not change for the next few months. Above all, market participants look with excitement on the US FED’s rate decision. Although a rate increase is assumed, external factors seem to determine when and by how much rates are increased. We believe the FED will not enter a new direction and tends to hold rates on a low level if asset classes signal uncertainty in the markets. The unemployment rate in the US shows a clear downward trend but without higher real wages, the economy does not look healthy. While the US is still waiting on higher wages, Europe is even further away to see a pickup. Together with falling oil prices that cheapens products and services due to second-round effects, the absence of real wage increases is a frightening deflation scenario.
In 2008/2009 and the following years, broad consensus denied that central bank and fiscal policy would import the Japanese deflation debacle to the US and Europe. And now we are exactly at this point. Five years later with vast amounts of printed money, high (youth) unemployment in Europe, without a sustainable growth story for most developed countries, and increasing social divergence, we achieved continuously ascending equity and bond markets.
A new survey highlights that Americans cannot weather one month’s expenses without their current jobs. Younger employees are heavily indebted from student loans. It is not a good precondition to build pressure in salary negotiations or to change jobs easily. Combining these aspects does not give a positive indication for real wage growth.
Interest rates could stay low for longer, the yield curve may invert and long-term dislocations (no return for savings, higher risk of poverty in old age, no structural growth in Europe) could be even more extended.
From our perspective, the low oil price is a measure of OPEC to throw out the marginal producers (also countries) which constitute the weakest link in the energy markets. A further downward move of oil into the regions seen in 2008 (30 USD/barrel) would not be a surprise. And yet, oil does not have to stay that cheap for a longer time and might move up very quickly in the aftermath. The Saudis, certainly the most reliable supplier of cheap oil, will benefit as well as the large integrated and service companies that can gather prime assets for a discount. As long as no bigger damage is done (distressed sales, defaults, project cancellations) oil should reside on these low levels.
Low oil could positively influence consumer behavior. If we experience these broadly expected large effects remains to be seen. We think two reasons work against it. One is the narrow budget situation of US households described above. Another reason comes from oil staying on low levels only for a limited time. Big discretionary spending will not be decided based on savings from gasoline for a few months. It remains to be seen how the US consumer translates his cost-savings into more consumption.
The Euro devaluation in 2014 was significant and from a purely intuitive perspective many market participants anticipated it. Currencies tend to have stable trends that elevate the pairs above any fair valuation range. Often these strong trends end abruptly, exactly when almost any investor expressed his expectation for a continuation of the trend. The EUR/USD pair might be close to this point.
We do not see larger dislocations stemming from the current weakness of the Eurozone’s common currency. A positive demand hike for single products from Europe can occur, nonetheless. In case the oil price moves back up to its old levels while simultaneously the Euro does not appreciate, it will be costly for oil importing European companies.
With still low interest rates and in general no change in the overall picture – China’s growth is down from its peak, the US focuses heavily on its own job market, and Europe tries to rescue itself in the eight year – the story for equity markets should remain intact. Participation in equity markets is still not high, valuations are not excessive and in some places even very modest, and investment alternatives (bonds, real estate) look exhausted. Compared to 2000 when we saw extreme valuations and private investors were flocking to the markets in euphoria, none of these phenomena are observed these days. In contrast with 2008, oil this time is falling amid a cyclical oversupply, not a negative demand shock. Last but not least, supply of shares available is further decreasing thanks to the buyback programs.
Therefore, we are confident equity markets will stick to their upward trend. We assume to see the fast drawdowns in equity markets again in 2015. Although these events will raise questions on valuations, risks, and other arguments to leave the market, the short downward moves will be driven by technical reasons as experienced in the previous years. The real risks often arise from areas no one focuses on (“the unknown unknowns”) or from the so-called safe havens (see the Swiss Franc event from last week).
Independent from any personal views on the market for 2015, we are committed to our systematic investment strategies and will continuously improve the strategies through research and development.