Shaping a portfolio for 2015 (vii): putting the pieces together

I expect 2015 to be a “normal” year, in contrast to the past six.  This is important.

Over the past six recovery-from-recession years, global stock markets have had a strong upward bias.  Yes, outperformance required the usual good sector and individual security selection.  But if “bad” meant up 12% instead of up 15%, most of us would be happy enough with the former.

This year, though, is more uncertain, I thin.  Whether the S&P 500 ends the year in the plus column or the minus depends on importantly on four factors:

–PE expansion.  Unlikely, in my view.  

–interest rates.   Arguably, rising rates may cause PE contraction, ash or bonds become more attractive investment alternatives to stocks

currency changes.  A rising currency acts much like an increase in interest rates.

profit growth.  In a normal year, earnings per share growth is the primary driver of index gains/losses.  It will be so for 2015, in my view.

Another point.  Four moving parts is an unusually large number.  There are other strong forces acting on sectors like Energy and Consumer discretionary, as well.  Because of this, unlike the past few years, where one could make a plan in January and take the rest of the year off, it will be important in 2015 to monitor plans frequently and be prepared to make mid-course corrections.

profit growth

Here’s my starting point (read:  the numbers I’ve made up):

US = 50% of S&P 500 profits.  Growth at +10% will mean a contribution of +5% to overall index growth

EU = 25% of S&P 500 profits.  Growth of 0 (due to euro weakness vs. the dollar) will mean no contribution to index profit growth

emerging markets = 25% of S&P 500 profits.  Growth of +10% (really, who knows what the number will be) will mean a contribution of +2.5% to             index growth.

Therefore, I expect S&P 500 profits for 2015 to be up by about 7% – 8%.

interest rates

The Fed says it will raise short-term rates, relatively aggressively, in my view, from 0 to +1.5% by yearend 2015, on the way to +3.5% by yearend 2017.  This plan has been public for a long time, so presumably at least part of the news has already been factored into today’s stock and bond prices.  What we don’t know now is:

–how much has already been discounted

–what the Fed will do if stocks and junk bonds begin to wobble, or emerging market securities fall through the floor, because rates are rising.  My belief:  the Fed slows down.

–is the final target too aggressive for a low-inflation world?  My take:  yes it is, meaning the Fed’s ultimate goal of removing the US from monetary intensive care may be achieved at a Fed Funds rate of, say, 2.75%.

My bottom line (remember, I’m an optimist):  while rising rates can’t be considered a good thing, they’ll have little PE contractionary effect.  Just as important, they won’t affect sector/stock selection.  The major way I can see that I might be wrong on this latter score would be that Financials–particularly regional banks–are better performers than I now anticipate.

If rising rates do have a contractionary effect on PEs, the loss of one PE point will offset the positive impact on the index of +6% -7% in earnings growth.  So the idea that the Fed will slow down if stocks begin to suffer is a crucial assumption.


currency effects

The dollar strength we’ve already seen in 2014 will make 2015 earnings comparisons for US companies with foreign currency asset/earnings exposure difficult.  Rising rates in the US may well cause further dollar appreciation next year.  Even if the dollar’s ascent is over, it’s hard for me to see the greenback giving back any of its gains.

Generally speaking, a rising currency acts like a hike in interest rates;  it slows economic activity.  It also redistributes growth away from exporters and import-competing firms toward importers and purely domestic companies (the latter indirectly).

The reverse is true for weak currency countries.  At some point, therefore, companies in weak currency countries begin to exhibit surprisingly strong earnings growth–something to watch for.

growth, not value

Typically, value stocks make their best showing as the business cycle turns from recession into recovery.  During more mature phases (read: now) growth stocks typically shine.


–Millennials, not Baby Boomers

–disruptive effects of the internet on traditional businesses.  For example: Uber, malls, peer-to-peer lending.  Consider an ETF for this kind of exposure.

–implications of lower oil prices.  Consider direct and indirect effects.  A plus for users of oil, a minus for owners of oil.  Sounds stupidly simple, but investing isn’t rocket science.  Sometimes it’s more like getting out of the way of the oncoming bus.

At some point, it will be important to play the contrary position.  Not yet, though, in my view.

–rent vs. buy.  Examples:  MSFT and ADBE (I’ve just sold my ADBE, though, and am looking for lower prices to buy back).  Two weird aspects to this: (1) when a company shifts from buy to rent, customers are willing to pay a lot more for services (some of this has to do with eliminating counterfeiting/stealing); (2) although accounting for rental operations is straightforward, Wall Street seems to have no clue, so it’s constantly being positively surprised.



Shaping a portfolio for 2015 (vi): the rest of the world

world GDP

A recent World Bank study ranks the largest countries in the world by 2013 GDP.  The biggest are:

1.   USA         $16.8 trillion

2.  China         $9.2 trillion

3.  Japan          $4.9 trillion

4.  Germany          $3.6 trillion.

The EU countries taken together are about equal in size to the US.

stock markets

From a stock market investor’s point of view, we can divide the world outside the US into four parts:  Europe, greater China, Japan and emerging markets.


In the 1990s, Japan choked off incipient economic recovery twice by tightening economic policy too soon–once by raising interest rates, once by increasing its tax on consumer goods.  It appears to have done the same thing again this year when it upped consumption tax in April.

More important, Tokyo appears to me to have made no substantive progress on eliminating structural industrial and bureaucratic impediments to growth.  As a result, and unfortunately for citizens of Japan, the current decade can easily turn out to be the third consecutive ten-year period of economic stagnation.

In US$ terms, Japan’s 2014 GDP will have shrunk considerably, due to yen depreciation.

If Abenomics is somehow ultimately successful, a surge in Japanese growth might be a pleasant surprise next year.  Realistically, though, Japan is now so small a factor in world terms that, absent a catastrophe, it no longer affects world economic prospects very much.


In the post-WWII era, successful emerging economies have by and large followed the Japanese model of keeping labor cheap and encouraging export-oriented manufacturing.  Eventually, however, everyone reaches a point where this formula no longer works.  How so?    …some combination of running out of workers, unacceptable levels of environmental damage or pressure from trading partners.  The growth path then becomes shifting to higher value-added manufacturing and a reorientation toward the domestic economy.  This is where China is now.

Historically, this transition is extremely difficult.  Resistance from those who have made fortunes the old way is invariably extremely high.  I read the current “anti-corruption” campaign as Beijing acting to remove this opposition.

I find the Chinese political situation very opaque.  Nevertheless, a few things stand out.  To my mind, China is not likely to go back to being the mammoth consumer of natural resources it was through most of the last decade.  My guess is that GDP growth in 2015 will come in at about the same +7%or so China will achieve this year.  In other words, China won’t provide either positive or negative surprises.

For most foreigners, the main way of getting exposure to the Chinese economy is through Hong Kong.  Personally, I own China Merchants and several of the Macau casinos.  The latter group looks very cheap to me but will likely only begin to perform when the Hong Kong market is convinced the anti-corruption campaign is nearing an end.


In many ways, the EU resembles the Japan of, say, 20 years ago.  It, too, has an aging population, low growth and significant structural rigidity.  The major Continental countries also have, like Japan, strong cultural resistance to change.  These are long-term issues well-known to most investors.

For 2015, the EU stands to benefit economically from a 10% depreciation of the euro vs. the US$.  As well, it is a major beneficiary of the decline in crude oil prices.  My guess is that growth will be surprisingly good for the EU next year.  I think the main focus for equity investors should be EU multinationals with large exposure to the US.

emerging markets

I’m content to invest in China through Hong Kong.  I worry about other emerging Asian markets, as well as Latin America (ex Mexico) and Africa.  Foreigners from the developed world provide most of the liquidity in this “other” class.  If an improving economy in the US and higher yields on US fixed income cause a shift in investor preferences, foreigners will likely try to extract funds from many emerging market in order to reposition them.  That will probably prove surprisingly difficult.  Prices will have a very hard time not falling in such a situation.


Shaping a portfolio for 2015 (iv): interest rates

The Fed has made it clear that it intends to begin the multi-year process of raising short-term interest rates back to normal sometime in 2015.  The agency says it expects to boost the Fed Funds rate from the current zero to around 1.5% by next December.

This is a good news/bad news development for investors.  On the one hand, the economic data clearly show that the US is finally–after six years–coming out the other side of the Great Recession.  On the other hand, rising interest rates are typically not good for securities markets ( a rising return on holding cash makes long-term investments like stocks or bonds look less attractive.).

If the Fed were to begin next April, it would have to do a .25% interest rate increase about every six weeks to get to 1.5% by yearend.  That’s just the beginning, though.  Fed documents indicate that the final goal is a Fed Funds rate of 3.5%.

what history shows

Rising rates are unequivocally bad for bonds.

In contrast, inpast periods of Fed-induced rate rises stocks have gone sideways to up.  That’s because the downward pressure that rising rates exert has been offset by upward pressure from strong-growing earnings.

 four differences today

1.  In past plain-vanilla recessions, interest rate hikes come pretty quickly after the worst of recession is over.  So consumers are just starting to spend (a lot) to satisfy needs deferred during the downturn.  In this case, however, we’ll be six years past the bottom.  Is there any pent-up demand left?    …probably not.  So the typical surge in earnings may be absent.  This is a minus for stocks.

2.  The Fed has been unusually clear  for a long time in publicizing what it intends to do and over what time frame.  Arguably, investors have absorbed this information and already made some portfolio adjustments in advance of the Fed’s actions.  I don’t see this in fixed income markets, but…

3.  The rest of the developed world hasn’t made anything close to thepost-recession progress in that the US has.  As a result,foreign interest rates  either remain at emergency lows, or are even dropping.  Rising interest rate differentials–and a strengthening US$–suggest that international fixed income investors may increase purchases of Treasury bonds, cushioning the fall in their prices.

4.  The Fed is acutely conscious of the repeated mistake that Japan has made over the past quarter-century of trying to return to normal too quickly–and pushing that country beck into recession instead.  Because of this, it’s possible that stock market weakness might cause the Fed to slow down planned interest rate rises.

my take

I think rising interest rates will make 2015 a sub-par year for stocks.  Will “sideways to up” hold true as it has in the past?  I don’t know.  I think a lot will depend on whether the Fed’s commitment to raising rates is greater than its wish to have relatively stable financial markets.  My guess is that stability is more important.

The Fed’s ultimate target for short rates is 3.5%.  I think that’s too high for a 2% inflation world.  I think 3% is more likely.  But let’s keep 3.5%.  Add a 2% real return to that and we get the endpoint for the yield on the 10-year Treasury,  5.5%.  This would imply a price earnings multiple for stocks of 1/.055, or 18x.  Arguably, then, the current multiple on stocks already discounts all the tightening the Fed is setting out to accomplish.

Even I think that the last paragraph paints too optimistic a picture.  What I’ve written may ultimately prove to be correct, but I don’t think the consensus would be willing to put much faith in this idea.

My starting out point is that interest rate rises will make next year a volatile one for stocks.  Without positive influences from earnings growth or foreign money flows, rising rates have the power to push US stocks down by, say, 5% in 2015..  At the same time, I think that good stock and industry/sector selection will enable investors to generate positive portfolio returns.

Shaping a portfolio for 2015 (iii): currency movements

When economies are deviate from the path that government policy would like them to follow, two basic options are available to get them back on track:

–internal adjustment, meaning the government alters tax/spending/interest rate policy to speed up/slow down the pace of growth; or

–external adjustment, meaning it changes policy with the aim of strengthening/weakening the currency.

In almost all cases, raising interest rates or raising taxes creates economic hardship and makes voters angry.  In bad times politicians have an overwhelming preference for external adjustment through currency movements, because the pain can’t be traced back to a given legislator’s votes.

rising/falling currency

A rise in a country’s currency acts like an increase in interest rates.  It slows down economic activity.  A decline in the currency does the opposite.

Either move has the secondary effect of shifting the composition of growth, as well.  A strong currency increases national wealth; it favors importers and hurts exporters and import-competing industries.  A weak currency does the opposite.

Right now, the EU and Japan are both following weak currency strategies aimed at simulating growth by devaluing their currencies.  In contrast, the US is about to begin the process of raising interest rates to wean its economy away from the emergency monetary stimulus it began in 2009.  The withdrawal of extra money will result in higher interest rates.  These differing policies are already having an effect on relative currency values, and therefore on publicly traded securities.

stocks in a weak currency country

The weak currency tends to stimulate overall economic activity.  Therefore, surprises in domestic earnings growth will tend to be positive–and good for stock prices.  Investors will also seek to benefit from foreign currency strength (i.e., the US$) by rotating their portfolios toward strong currency earners.  These will either be multinationals with significant operations/assets in the strong currency country or exporters.  They will also tend to shun importers, whose offerings will be more expensive and therefore less attractive.

stocks in a strong currency country

Holders of strong currency assets get more bang for their buck in buying weak currency goods and services (like vacations).  They are better off simply from the fact of local currency appreciation.  But for the local stock market, the currency appreciation isn’t an adulterated plus.  Quite the opposite.

The appreciation slows down domestic economic activity, making negative earnings surprises a greater possibility.  In addition, the strong currency value of a firm’s foreign (weak currency) earnings and assets is diminished.   Both will mean that year-on-year earnings comparisons in foreign operations will be unfavorable.  Neither is easy to predict, so the possibility of earnings disappointment will increase.

Therefore, holding stocks in a strong currency country isn’t always just a walk in the park.

Stock market participants typically deal with this issue by rotating their holdings toward importers and purely domestic firms.

other investor influences

carry trade

Weak currency fixed income investors may shift their holdings toward strong currency sovereign bonds.  We’re seeing this already being done this year by EU portfolio managers, who are buying Treasury bonds in large amounts.  To them buying Treasures seems like shooting fish in a barrel.  They get an immediate yield pickup plus a potential currency gain.

EU alternative investors can amplify their returns by shorting their own sovereign bonds and using the funds to buy Treasuries.  That’s the carry trade.

Although the Fed controls the overnight-money Fed Funds rate, foreign portfolio investors may well keep long-term US interest rates lower than they would be if domestic investors were the only market participants.

foreign investment

Foreigners may judge that the currency gain they achieve by buying US stocks will more than offset possible stock price softness due to slower earnings growth. There’s no general rule I know of to decide whether this is a good move or not.  In the 1980s, the return on Mexican stocks was fabulous, even though the peso lost virtually all its value during the decade.  Japanese stocks were also super in the same time frame, even though the currency was very strong.

for 2015

My experience is that traders in the currency markets are way ahead of me in evaluating where currencies should be.  I think I’m better off concentrating on general trends–orienting my active stock holdings in the US toward strong currency beneficiaries and my foreign positions toward weak currency beneficiaries.

One other tactic is to try to find companies that are growing fast enough that currency won’t matter much  (see my post on Pandora).

One final note:  the 1997 Asian economic crisis was triggered by dollar strength.  Many regional firms had borrowed extremely heavily in dollars because interest rates on local debt were much higher.  Balance sheets were destroyed when the dollar appreciated.  If there’s similar trouble in 2015 look for it in South American and Africa, not Asia.




Ackman, Actavis, Allergan and Valeant

This is a situation I didn’t pay much attention to while it was going on but which I think has interesting implications for merger and acquisition activity in the future.  It doesn’t seem to me, however, that investors in general understand exactly what went on.

The bare bones:  Bill Ackman, of Pershing Square fame (and J C Penney infamy) bought just under 10% of Allergan, the maker of botox, and urged the company to put itself up for sale.  Ackman then allied himself with serial pharma acquirer Valeant to make a joint hostile (meaning against the wishes of the target) bid for Allergan.  Actavis, a third pharma company, emerged as a “white knight” to rescue Allergan from Valeant’s clutches with a bid that topped Valeant’s offer by about 15%.  Valeant conceded defeat.


This is the latest enactment of one of the oldest dramas on Wall Street.  A “black knight” makes a hostile bid for a vulnerable company.  The target firm, realizing that it is now in play, understands that at the end of the day it will most likely be acquired.  The only choice that remains to the target is to choose who the acquirer will be.  Invariably, it determines to join with anyone but the black knight that has caused all this trouble.  That’s why hostile bids fail as often as not.

For this reason, one of the bigger problems in the m&a game is that no one really wants to be the black knight.  Once the villain has appeared, however, there’s usually no trouble in finding someone willing to ride to the rescue.  In most cases there’s at least one potential acquirer hoping against hope that someone else will make the first move.


The Ackman innovation: in February, when he and Valeant became co-bidders for Allergan, he agreed to pay Valeant 15% of his Allergan profits if a third-party ended up acquiring Allergan.  This created a win-win situation for Valeant, which would either come away with Allergan or with several hundred million dollars for having played the black knight role.


–what was the Allergan price at which Valeant shifted from hoping to acquire the company to wanting to collect a fee from Ackman?;

– did Valeant ever really expect to own Allergan?;

–most important, will this maneuver work again?

I don’t know  …but the answer to question #3 depends a lot, I think, on the answer to #2.


Jim Paulsen on 2015 (ii)

To recap:  yesterday I wrote about the latest investment newsletter from Jim Paulsen, a strategist at Wells Fargo.  In it he talks about a belief held widely (including, up until now, by me)–that the Fed’s program of raising interest rates from the current emergency-lows up to normal will be bad for bonds but have little impact on stocks.

How can stocks fare well as rates rise?

…because in past instances of post-recession rate increases, the negative effects of higher rates have turned out to be at least offset by the positive influence of stronger corporate earnings.  Hence, stocks go sideways to up.

Why is this time different?

Past tightening episodes have generally followed relatively mild recessions.  Tightening has come, say, a year after the bottom in economic activity, when the economic bounceback from the downturn is in full force.  Today, however, we’re more than five years past the recessionary low point.  Deferred demand has long since been satisfied.  So we can’t expect the same oomph from earnings comparisons that we’ve gotten in the past.  In fact, in Paulsen’s view, stocks are most likely to go down next year as Fed tightening begins.

Mr. Paulsen is smart, experienced–and has been right about stocks for at least the past five years.  So he’s someone whose opinion we have to take seriously.  He;s also a bull making a bearish statement.  For that reason alone, it’s worth consideration.

Another point in Paulsen’s favor:  the rest of the world seems not able to provide much support for S&P 500 earnings next year.  If anything, non-US businesses will be a drag on profit growth.

How might Paulsen be wrong?

I can think of three ways:

1.  It’s hard to predict the Fed’s tactics in raising rates.  The agency’s current plan is to start raising short-term rates sometime in the Spring and boost them by 0.25% every month or so, to arrive at around 1.50% by yearend.  However, if this timetable makes the stock market start to unravel, it’s conceivable–likely, in my view–the Fed will slow the pace, or even stop until stocks stabilize.  The disastrous moves by the Japanese government in the 1990s to prematurely return to normal–and the consequent lost quarter-century of economic growth–appear to be very fresh in the Fed’s mind.

2.  The Fed has been highly vocal for a long time about its plans.  They come as no surprise.  It’s possible, therefore, that investors have already made some adjustments in their thinking, and in their portfolios.  If so, the rate rise won’t be as harmful to financial markets as might be.

3.  (or maybe 2a, or both)  For investors not willing to hold highly illiquid investments in large amounts (that is, for almost all of us) the investment choice is among stocks, bonds and cash.  The return on cash will be negligible for a considerable time.  So the practical choice is between stocks and bonds.  Two points:

–the 30-year Treasury currently yields 3%.  An earnings yield on stocks of 3% translates (in the way Wall Street has generally worked since the 1980s) into a 33.3x price earnings multiple.  The S&P 500 is currently trading nowher close to that level, however.  It’s at less than 20x earnings.  20x earnings is the equivalent of a 5% yield on the 30-year Treasury.

I take this to mean the markets are already factoring into today’s stock prices a considerable rise in fixed income yields.  This doesn’t mean stocks won’t decline as rates start to rise.  But I think it does mean that part of this is already in prices and that the downside to stocks could be limited.

–we’re already beginning to see European bond managers buying US bonds.  They see: safe haven, higher current yields and rising currency (in euro terms) as offsets to possible losses from rising rates.  As rates begin to move higher, this trend may accelerate, bringing a higher dollar and a subdued effect on long-term bonds from rising short-term rates.  If long-term rates don’t rise less than expected, the effect on stocks should be positive.

what I’m doing

The rising currency scenario isn’t an unadulterated plus for the US.  Currency rises act in much the same way as interest rate increases do.  They lower economic activity.  Of particular concern to stock market investors, a dollar rise against the euro will lower the dollar-denominated results for S&P companies with European exposure.  That’s about a quarter of the S&P’s earnings total.

I don’t think we have to decide right away how stocks and bonds will play out next year.  But we do have to continue to assess possible outcomes and mull over what we want to do as new news makes one or another outcome seem more likely.

Pandora (CPH: PNDORA) and the dollar

This is one case where it’s easier to write the name than the symbol, which includes its principal trading market, Copenhagen.

Pandora is the jewelry company that burst on the scene early in the decade with an innovative line of charm bracelets.  It IPOed to much fanfare in Copenhagen in 20111   …and almost immediately collapsed as its product began to be knocked off by established jewelry chains.

The company has since rebuilt itself.  The stock is now about 10x the price at its nadir almost exactly three years ago.  I’m still learnings the story–and this is not a stock I feel comfortable enough with to recommend that anyone else buy it.  But the turnaround seems to have been accomplished with better management, stronger control of inventories and the introduction of a line of rings, which are harder to knock off.

There are more pluses to the story, like development of the company’s own retail channel and increasing e-commerce presence, which is boosting purchases by men.  But the knockoff issue still exists:  here in the US, for example, Signet Jewelers’ Jared sells Pandora; its lower-end but much larger sibling, Kay, sells its own knockoff line.


Two ideas attracted me to Pandora a few months ago:  the rings, and the possibility that continuing economic weakness in the EU would force people to trade down further–meaning that a company like Pandora might increasingly be in the sweet spot for jewelry.  My main worry is that I’m very late to the party, as the stock chart illustrates.


The main reason I’m writing about Pandora, though, is not to highlight the company but to point out a fact about the dollar.  In Danish kroner, I’m up by 11% since buying the stock in August.  In US$, however, I’m up a tad less 3%.  Yes, I’ve wildly outperformed European stock indices but I’ve given almost all of it back in losses on the currency.

My point:  that’s what’s been happening to every US company that has a presence in Europe (or in Japan, for that matter) since May.  Of course, not all of them have sales that are way above average for Europe, so they generally have US$ losses on operations.  On the other hand, the biggest of them will have hedging operations that temper the near-term effects of currency fluctuations.

Given that about a quarter of the earnings of the S&P 500 come from Europe, it seems to me that the combination of weak economic performance there plus weak currencies represents the biggest threat to earnings growth facing the S&P 500 today.

I don’t think this issue is a reason to sell US stocks across the board.  It’s more a reason to reposition away from firms with European exposure.  Upcoming earnings reports from companies like Tiffany will give us more information.

Conversely, European currency weakness is setting up another opportunity to buy Europe-based multinationals with significant dollar exposure, just as we had several years ago.  Typically, the negative effects of currency depreciation are factored into stock prices first, and the positive effect on earnings only with a lag.


PS.  On December 3, 2014, in kroner I’m up about 22%, in US$ about 12%.



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