Category Archives: Shaping a portfolio for 2015

Shaping a portfolio for 2015 (v): the US

December 10, 2014 By in Portfolio management, Shaping a portfolio for 2015, Strategy Tags: , , , , 2 Comments

a healthier economy

2015 will likely be the first normal year for the US economically for a long time.  The unemployment rate is close to full employment levels; job creation is high–and accelerating; recent signs suggest that wages are beginning to rise.

Wage gains are important for two reasons:

–higher wages imply more consumer spending, which means accelerating economic expansion, and

–the resulting increase in the price level diminishes the possibility of deflation.

alone in growth mode

The EU is, generally speaking, a less dynamic area than the US.  But it is also years behind the US in putting recession in the rear view mirror.  It is still struggling with structural problems–Greece, for example, is flaring up again.

I continue to believe that Abenomics is not going to solve Japan’s economic woes.  So pencil in no growth there.

China is attempting to transition from being an export-driven economy to a doemstic demand-oriented one.  As one would expect, it is encountering tremendous resistance from the export establishment.  This struggle will keep the Chinese economy range bound around 6%-7% GDP growth for a while.  Big numbers, yes, but no acceleration like the US is experiencing.

a lower oil price

I’ve written about this in more detail earlier in this Strategy series.  For the country as a whole, a lower oil price is a plus.

Assuming, as I do, that prices will stay around this level, effects will likely be:

–the biggest percentage change in disposable income for the less affluent,

–diminishing interest in alternate energy sources

–economic, and possible political, troubles for oil-producing countries–Russia, the Middle East and Africa.

We’re already seeing renewed interest in gas-guzzling cars and trucks in the US.  But also–a good thing, in my view–politicians are beginning to talk about raising taxes on gasoline.  This would provide funds–at least in theory–to repair decrepit roads and bridges.  By encouraging conservation, it would also lessen the long-term economic power of the oil producers.  And it would bring US policies more in line with the rest of the developed world.

rising interest rates

The good economic news opens the door for the Fed to begin to raise interest rates from the current emergency-low levels.  I’ve written about this too in more detail earlier in this Strategy series.

Normalization of rates is a long-term plus.  But rising interest rates will also tend to slow growth a bit, both by raising the cost of borrowing and by rising interest rate differentials between the US and other countries giving strength to the US$.

structural factors

The Internet continues to be an amazingly powerful force of creative destruction in the economy.  No end in sight.

Millennials have surpassed Baby Boomers as the largest segment of the population.  In addition, Millennials will be the chief beneficiaries or rising wages, while Boomers will see their incomes drop as they enter retirement.

my bottom line:  the fact that the US is coming further out of recession is a huge long-term plus, both for the economy and for US financial markets.  Purely from a stock market point of view, however, there are a lot of conflicting variable in the equation for 2015.  And that’s apart from trying to handicap what the markets have already begun to discount.  More about this when I put all the pieces together in a couple of days.

Shaping a portfolio for 2015 (iv): interest rates

December 9, 2014 By in bond market, securities markets, Shaping a portfolio for 2015, Shaping a portfolio for 2015 (iv); interest rates, stock market, Strategy Tags: , , , , , , , , Leave a comment

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

December 8, 2014 By in currency effects, Shaping a portfolio for 2015, Strategy Tags: , , , , , Leave a comment

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.

 

 

 

Shaping a portfolio for 2015 (ii): energy

December 4, 2014 By in Energy, Energy, Industry Analysis, Shaping a portfolio for 2015, Strategy Tags: , , , , , , Leave a comment

From 2011 through the first half of 2014, the world crude oil price averaged $110 a barrel, more or less (let’s not worry about quality differentials and stuff like that–this is the BIG (and simple) picture).  Now it’s $70.

World oil production is 90 million barels a day.  So a $40 a barrel reduction in price means $3.6 billion a day no longer leaving the pockets of oil consumers and landing in those of the oil producers.  That’s $1.3 trillion a year–or about 8% of the total GDP of the United States.

The important investment questions are:

–does oil stay at this price?, and

–who are the winners and losers.

Let’s take the second first.

oil production and consumption

net importing areas, i.e., winners

Asia         20.4 million bbl/day; of that, China accounts for 5.6 million, Japan 4.4, South Korea 2.5, India 2.3

Europe     10.5 million bbl/day

North America     4 million bbl/day;  the US imports 6.7 million, Canada and Mexico are both exporters

net exporting areas, i.e., losers

Middle East     19.2 milllion bbl/day;  Saudi Arabia is 7.1 million

Eurasia     8.8 million bbl/day; Russia is 7.2 million

Africa     5.7 million bbl/day.

The US is now the largest oil producing country in the world, at 12.3 million barrels/day.  It is followed by Saudi Arabia and Russia, both at 10+ million bbl/day.

On a net basis, Asians and Europeans get the biggest windfall from lower oil prices;  the Middle East and Russia lose the most.  The US situation is more complex.  On the one hand, the nation as a whole is a net winner from lower oil prices.  On the other, the net win is made up of large gains by drivers everywhere, airlines and heating oil users in colder areas, partly offset by substantial losses in oil-producing states like North Dakota and Texas.

second round effects

There are two varieties:

–historically, a considerable portion of the money collected by oil producing countries is not spent.  Instead, it’s saved, or “recycled” into international financial markets.  Taking the Middle East, Eurasia and Africa together, there’s now a half-trillion dollars a year being spent in dribs and drabs by consumers outside these areas rather than being parked in sovereign wealth funds, private equity or hedge funds.  Bad for fund managers and bankers, good for consumption.

–Some consumers are abandoning hybrids and starting to buy gas guzzlers again.  Some new shale oil projects may no longer be economical.  Some of the urgency is leaving the alternative energy area.  These counter-trend developments are probably too small to matter much today, but they ultimately have the potential to help reverse the price decline and therefore are worth monitoring.

the first question

My guess is that the oil price stays around where it is now.

But that’s really just a guess.

As investors, we have to deal with ambiguity and uncertainty every day.  It’s more important for me to understand that I’m using this assumption in structuring my portfolio than to be 100% sure that I’m correct.  That way I can keep my eye out for changes and plan what I’ll do when/if I see them. In any situation where a professional genuinely has no insight, the plain-vanilla strategy is to equal weight the area.  I imagine that most professionals will have less than the S&P 8% weithging in Energy going into 2015, however.

In the active portion of my holdings, I’ve had virtually no Energy for some time.  I’m going to continue that stance. But I’m going to look around for some Retail or Restaurants to add in the US or EU. I’m leaving my passive holdings alone.  I suppose I could short an oil ETF, but I’m confident in my case that that wouldn’t work out well. At some point, well ahead of any reversal in the oil price, the stocks in the Energy sector will bottom out.  We should be watching for this.  I don’t think we’re anywhere near that point yet, however.

Shaping a portfolio for 2015 (i): a look back at 2014

December 3, 2014 By in Portfolio management, Recent Market Action, Shaping a portfolio for 2015, Strategy Tags: , , , , Leave a comment

Yes, we’re barely into December.  But within ten trading days Wall Street will be closing up for the year.  There’s little professional investors can do at this point to influence how their year will pan out, other than to avoid possibly mucking things up through short-term trading.  The accountants will be eager to get a start on closing the books. So they’re happier if accounts don’t trade in the second half of the month.  In particular, they won’t want trades to happen that will hang over, unsettled, into 2015.  As a practical matter, the last two weeks of the year are the best chance professionals have to rest–and virtually everyone takes advantage of the opportunity.

In other words, we’re already close enough to the end of the Wall Street year to draw some conclusions about how the year has gone.

Well, then, how did my Strategy for 2014 hold up?

what went well…

–To start with the most basic, this time last year I thought stocks would produce gains again in 2014, although on a more modest scale than in 2013.  I expected a rise of 7% – 8% for the S&P 500 (not counting dividends), driven by earnings growth and with basically none of the price earnings multiple expansion that characterized 2013.

That has more or less turned out, although earnings have been better than I had anticipated.  Before the start of trading today, the S&P is up by 11.8% since January 1st.

–I thought outperformance would come from a mix of growth stocks, which usually do progressively better as the economic cycle matures, and high dividend payers.  My rationale for the latter was that a yield of 3%+ would be a good start on a total return that would come in at 10%-.  I mentioned MSFT as a particularly interesting company of this sort–but I also suggested looking in Utilities, Telecoms and master limited partnerships (assuming a tolerance for a messy tax return).  MSFT has done extremely well, thanks in large part to jettisoning Steve Ballmer.  Utilities have also been stars, at +21% as a sector ytd.  On the other hand, Telecoms have been caught in the winds of structural change and are little better than flat. The MPLs I’ve looked at have generated income but little in the way of capital gains.

–I also thought short-term volatility would be high for stocks.  It has been   …and I think this will continue to be true in 2015.

…and not so well

–I thought that the EU would be showing increasing signs of life—not robust growth, but at least a healthier pulse–as the year progressed.  I also expected the Chinese economy to bottom out sometime in the first half and begin to strengthen in the second.  Both areas have been weaker than I thought.

I was more than bailed out in the case of the Shanghai (+31% ytd) and Shenzhen (+19%) exchanges, which were driven higher by the recent Beijing announcement of a trading link between Shanghai and Hong Kong.  But Hong Kong is flat ytd.  More important, around mid-year, evidence began to emerge that the EU was starting to slow down, not pick up.  Subsequent market and currency declines have made Europe a very tough place to make money this year.  The biggest issue was not how to deal with a rising euro, as I expected a year ago, but how to defend yourself against a falling one.  There was plenty of time to reverse course on the EU, but the fact remains that I didn’t see the slowdown coming.

other stuff

A year ago, I expected Staples to perform well, on the same rationale as MSFT   …but also because the sector has outsized exposure to the EU.  Despite my mistake on the EU the sector has outperformed.  But that’s because of a fall in agricultural raw materials prices.  So this one is a case of better to be lucky than good.

I haven’t been a big fan of Energy for some time.  That’s mostly because the big oils generally get little benefit from rising petroleum prices.  Also, I’ve been too lazy/uninterested to do the work needed to sort out winners from losers in the shale oil/gas business in the US.  Still, I was surprised that the oil price has fallen so far.  This is a net positive for stocks, in my view.  There’ll also be a time to take the contrary view on Energy and buy.  I don’t think we’re there yet, however.

a letter grade?

I’d give myself some sort of a B.  A big mistake on the question of US vs. rest of the world, but offset somewhat by the idea of rmeaining positive on on stocks.