Blackthorn Quarterly Letter
I learned that courage was not the absence of fear, but the triumph over it. The brave man is not he who does not feel afraid, but he who conquers that fear. – Nelson Mandela
The dawn of any New Year brings the anticipation of what might be and the temptation to make predictions about how things might unfold. While we are not in the crystal ball business we find the turn of the calendar a useful time to analyze the current landscape and perhaps see a bit of what the next year may hold in store. Seminal moments in investing tend to happen around the calendar as we humans are prone to repeating behavior at certain times of the year.
Before we get to the seasonal effects let’s start with what analysts around Wall Street are saying 2014 holds in store. The consensus forecast on the street for 2014 is one of the most bearish forecasts in years. While 2013 may have defined the term “broad based rally “analysts expect the S&P 500 to close higher by only 5.8% by the end of 2014. That is a little more than half the average return predicted by analysts over the last decade. Analysts are obviously a bit more reluctant about predicting outsized gains after such a stellar year in 2013.
Given the outstanding performance of the S&P 500 in 2013 it makes sense to investigate what has happened in years that followed a plus 20% year. From Piper Jaffrey comes research that points to another up year for stocks but not without some bumps in the road.
Since 1945 the S&P 500 has posted 21 annual gains of more than 20 percent. The average gain the next year was 10 percent, with the index up 78 percent of the time. However, every one of those “good” years saw drops of at least 6 percent and up to 19.3 percent.
As you know we look to all sorts of trends to gauge market sentiment. One trend worth noting is the US Presidential Cycle. Thanks, also to Piper Jaffrey, comes an outline of Year 2 of the US Presidential Cycle where we can look for more hints as to what 2014 has in store in this, a mid-term election year.
More particularly, the second year of the cycle—the year when midterm elections are held—tends to be volatile, with substantial pullbacks, corrections or outright bear markets not at all uncommon. The typical return during such years is just 5.3 percent, or barely half the norm.
Piper Jaffrey points out that since 1930, pullbacks during midterm years have averaged 17 percent.
We expect to see more turbulence than we did last year as the Federal Reserve begins to back away from it Quantitative Easing policy. 2014 may also see Washington DC go into hyper dysfunctional mode as the Senate and House are up for grabs. One thing to remember is the fact that it is common to have volatility in the stock market. What is uncommon is to have the market move up in a straight line as it did in 2013 with little or no correction along the way. We expect the market to finish on the plus side again in 2014 but there is certainly room for a pullback along the way as the current bull market is now over 4 years old. The internals of the market have eroded a bit of late as small caps have begun to lag the broader market, margin debt is now striking at highs not seen since 2007 and short interest is hitting lows not seen since that peak in 2007. While history does not repeat we can be fairly certain that it does rhyme given the tendencies for human beings to seek patterns and to respond in a psychologically consistent way.
Late last month the Federal Open Market Committee (FOMC) decided to taper their purchases of US Treasuries and Mortgage Backed Securities by $10 billion. While this may have taken some market participants by surprise it seems that the committee is sensing a diminishing return on their investment in QE and are seeing its impact on economic conditions diminish as well.
“A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment,” FOMC Minutes 12/17-18/2013
There was also concern noted by committee members that one of the consequences of QE was it could be providing incentives for excessive risk taking in financial markets.
In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.“ – FOMC minutes 12/17-18/2014
This path of tapering and eventually ending of QE has been a bumpy one in years past. In fact, the ending of the last three QE programs has had the impact of actually reducing bond yields and negatively impacting the stock market. How will the tapering and possible end of QE impact markets in 2014? Will the market continue higher given that the Fed is still purchasing assets in the open market or will market participants try to exit the stock market before QE’s end? Since the dawn of the financial crisis we have postulated that the hard work for the Fed would come when it was time to withdraw.
The bond market has been a dangerous place to be in most investor’s minds and to ours as well. Our response to inflated bond prices has been to underweight our allocations to bonds as well as shorten the duration of our portfolios to the 5-7 year range. This was done in order to account for the risk of rising interest rates. Citigroup Foreign Exchange Technicals group has done extensive research that shows, counter intuitively, that Quantitative Easing leads to higher rates during QE and that the end of QE brings lower rates on the US Treasury 10 year. Citi’s thesis is that more QE leads to a rush into higher risk assets and the dumping of bonds to the government as the buyer. The end of QE brings money back into safer assets like the US 10 year as it flows out of stocks and hot money destinations like emerging markets.
While we are underweight bonds and have shortened the duration of our bond portfolio in recent years the above analysis may lend to actually lengthening our duration for a time if QE is indeed coming to a close. Another reason that the bond market may find support here comes from a side effect of the equity rally starting in the spring of 2009. The doubling of the stock market from its low in March of 2009 has had the additional benefit of inflating assets held by pension funds. Pension funds are now more funded then they have been in years. Pension fund managers may now begin to decrease their equity allocations and tilt it towards one more heavily weighted in bonds. Pension funds are notoriously conservative in their investing. No pension fund manager, after having lived through the crisis of 2008, will be willing to risk their newly found “fully funded” status. A movement out of equities and into one more heavily weighted in bonds may help forestall giving back those well earned gains and their all important fully funded position.
Remember, central banks don’t create growth. They only pull demand forward much as they have pulled market returns forward. The Fed has pulled market returns forward by pushing investors into riskier assets. While we are looking for a bumpy 2014 US corporations and banks have buttressed their balance sheets for any storm that may approach whether that storm is due to lessened QE, a Chinese banking crisis, higher interest rates in the US or a backlash from political ineptitude as Congress prepares for midterm elections.
Our companies are the most financially prepared and most productively operated they have been at any time during the nearly four decades since I graduated from business school. –Richard Fisher FOMC Committee Member – 12/9/13.
The key to 2014 may be how the FOMC manages their playbook. The FOMC hopes to engineer a “soft landing” as they try to ease back away from their Quantitative Easing policy and attempt to wind down their balance sheet. We are of the inclination that engineering a soft landing will be extremely difficult and not without some spasms of volatility given the extreme nature of QE. Thus our expectations for 2014 are for increased volatility and single digit returns for both bonds and stocks as QE is withdrawn from the market.
If a selloff in asset prices does occur it will be important to remember that the positive trends in the United States are still in place. US Corporation’s balance sheets have been fortified, unemployment in the US is shrinking and the idea of energy independence being brought forth by the Shale revolution gives the United States a clear set of advantages when it comes to growth on the world stage. The stock market, overvalued as it is after having doubled from its prior cyclical lows, is still a better bargain today than it was in 2000. Any major sell off from here may turn out to be a great buying opportunity when we look back 10 or 20 years from now.
Going forward we will continue to monitor bond yields, the progress of Quantitative Easing, the potential mismanagement of the US Congress, Emerging Markets, Europe and China. What happens in those areas will give us clues as to how to react and re-allocate our portfolios accordingly. We wish you a happy, healthy and prosperous New Year and we look forward to seeing and speaking with you in 2014.
A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference. – Robert Rubin