2015 Annual Forecast

It’s already February, but for many readers this is the first communication of 2015 so, Happy New Year! It’s been a great 6 weeks so far and we’re looking forward to many more to come. Let’s get into it…

In 2014 most of our forecasts were falling into place until late August when the value of the Euro, Japanese Yen, and oil all plunged. Inflation expectations immediately fell, followed by long-term interest rates. Although I expected dollar strength, I didn’t anticipate the sea change we experienced. I find no solace in the fact that almost everyone else seems to have been similarly blindsided. As it turned out, those surprises validated my core thesis; the extraordinary high level of US corporate profit margins is unsustainable. A trifecta of earnings-shattering events is presently unfolding:

  • Plunging energy prices are decimating oil company profits as well as companies that supply the energy industry and its employees;
  • The strong dollar is hitting profits of companies that rely on exports and foreign subsidiaries to pump up their bottom line;
  • Bank earnings are being hit by a flatter yield curve as short-term rates creep higher and long-term rates fall.

These realities notwithstanding, US stock prices managed to rally into year-end while miners of precious metals prices made new cyclical lows.

Frankly, this made no sense at all…then reversed in January. In the meantime, it temporarily upended our forecasts and strategies at the end of last year. Years of zero interest rates and quantitative easing induced by the Fed have produced a myriad of economic distortions. Massive stimulus provided by central bankers primarily benefitted areas of the economy where debt levels are high (by lowering interest expense) and had a minimal effect on the rest of the economy.

Until these recent events, my outlook for the US economy in 2014 and early 2015 was relatively ebullient (despite my concerns about the equity and credit markets). My economic optimism was driven by the sharp rise in bank lending between mid-2013 and the first 3 quarters 2014.

Expansion of bank-created credit is normally associated with significant expansion in business investment. That investment is what typically drives productivity, jobs, and growth. Although there was some investment growth, most of the borrowing in 2014 fueled other things providing only minimal economic lift. Despite the slowest recovery on record, US growth still outpaced our major global competitors for the last five years. While the Fed

would like to take credit for this, our outperformance is almost entirely the result of a doubling of US energy production since 2007.

It may not come as a surprise to anyone watching the energy sector over the last 7 years that roughly 100% of job growth since the beginning of the Great Recession has come from Texas where energy CAPEX has boomed.

Business investment growth across the board has been dawdling near half the long-term average despite record growth in energy related CAPEX. Even with other areas picking up, energy still comprised about 1/3 of all S&P 500 CAPEX recently. Soaring US energy production combined with legal restrictions on oil exports to depress US energy prices well below global levels. This provided a huge global competitive advantage and a GDP-boosting reduction in the trade deficit. Over time reduced US oil imports combined with a Chinese slowdown produced a global energy glut.

Now that global energy prices have plunged most of the US cost advantage has been eradicated. The result is depression like conditions for energy producers, be they corporations, oil field workers, or countries like Russia, Venezuela, Iran, or Libya. These sudden changes have caused me to reassess the bank lending that fueled my optimism. Rather than reflecting a widespread investment expansion, recent growth in US bank loans primarily financed:

  • Securities purchases fueled the stock market and junk bond bubbles as companies issued debt to buy back shares and margin debt rose to record levels;
  • Excessive energy exploration and drilling that is now reversing;
  • Student loans that have saddled graduates with a huge burden that is depressing home sales and producing few high paid jobs
  • A bubble in securitized subprime auto loans reminiscent of the housing mortgage bubble although on a much smaller scale.

US growth in the coming year is likely to remain positive, but it will be weaker than I expected as recently as a few months ago. It will take some time to assess all the implications, but a few key themes are becoming clear in 2015:

  • Large energy price moves result in a transfer of wealth between energy producers and energy consumers. Falling energy prices are a windfall for energy consumers, but the positive impact on the economy will be much smaller than during previous oil price declines. Unlike most of the last half century, the US now produces as much energy as it consumes (the US still imports some oil, but exports almost as much energy in the form of coal).
  • For most of the last 50 years, lower oil prices reduced US payments to foreign oil producers. Today, lower oil prices mean that consumers send less money to Texas, North Dakota, and Kern County CA. While potentially a zero sum game over time, in 2015 the drag of reduced energy revenues on output, profits, jobs and investment will be bigger than the contribution from increased (non-energy) consumption. This will become very apparent in the last half of the year when US growth stalls. Evidence already surfaced in GDP growth data for the final quarter of 2014, which dropped 45% from the prior quarter. Despite lower oil prices, December consumer spending registered its largest drop since 2009. I expect 4th quarter growth to be revised even lower in the next few months.

Consumers are paying off debt and saving rather than spending most of the benefit from lower pump prices. Only if prices remain low for a couple of years will consumers completely believe it will last and spend 70% of the savings. Even then, most of that increased spending will go to imports that boost growth OUTSIDE the US.

Oil prices will bounce around a lot but most likely fall further before bottoming in 2015. US oil output continues to rise even as speculators have bid up prices from their recent lows around $45 for WTI in response to an announcement of planned reductions in drilling and exploration. Eventually US production will fall but according to an analysis by Citibank, US oil production will continue to increase through at least the third quarter. Global storage tanks are already full, so it is unlikely the recent rally above $50/bbl will hold. Even after US production is reduced in 2016, prices are unlikely to rebound above $70/bbl for several years. Output is increasing but profits at energy companies and their suppliers are plummeting. It won’t be long before the companies that sell to their workers feel similar pain.

This makes the energy space potentially interesting as an investment, but not yet. We are looking for an entry point when true bargains appear. Capitulation (and the leg down toward the bottom where we begin buying) will likely happen when energy companies begin cutting their dividends on the back of prolonged weak revenues.

  • An overvalued (trade weighted) dollar (that has risen 18% in value since last May) will compound the negative impact of falling oil prices on US economic output, profits, jobs, and investment. Multinational companies in the S&P 500 derive almost half their earnings from exports and foreign subsidiaries. Those earnings will also drop unless they are able to cut costs (not a recipe for faster growth) or raise prices and sales by a similar percentage (highly unlikely in a sluggish global economy). The combination of an overvalued dollar and lower oil prices will help Europe, Japan, and China. These global export competitors are big energy importers. Lower oil and a strong dollar will mitigate some other headwinds faced by those economies.
  • The flatter yield curve and weak loan demand will hinder bank profits as well. Faster growth requires acceleration of bank lending, but in the last few months, loan growth has slowed from 11% to 7% and defaults have started to appear in the subprime auto loan market. Banks have plenty of excess reserves, but loan demand from borrowers with good credit remains weak. Consumers continue to pay down debt while corporate borrowing outside the oil patch has been limited to bond issuance to finance share buybacks. Even the big energy companies were issuing bonds to buy back shares during the last few years. Even Chevron and Exxon just announced massive reductions in their buyback programs and will need to borrow money to pay dividends.

Banks make lending profits primarily by borrowing short-term at low rates and lending long-term at higher rates. Long-term rates have fallen while short-term rates have inched higher. This produces further downward pressure on bank profits that no longer benefit from the forces I’ve discussed in recent letters; massive home refinance activity, reductions in loan loss reserves (now at a minimum) and securities trading (limited by post crisis regulations).

Record corporate profit margins have been skating on thin ice for a couple of years. It looks like year over year earnings growth will turn negative in 2015. Fewer and fewer companies are upping their guidance, while more and more are issuing warnings. Even in 2014, over half of the modest 4% S&P earnings growth came from a single company, Apple. The cards are already on the table for 2014. Q4 corporate earnings will be lower than Q3 earnings. Year-over-year Q1 and Q2 earnings are poised to show declines from the prior year. The yield curve is flattening. Investor behavior has shifted from risk seeking to risk aversion. Market divergences are increasing while credit spreads are widening. Unlike the economy or so many of the “headline” indicators we hear from the TV, these factors are all historically reliable indicators that scream overvaluation. Cyclicality and mean reversion call for a serious bear market.

  • The bubble in US stocks and high yield bonds was fueled by both zero interest rates and the expectation that corporate profit margins (already 50% above historical norms) would continue to rise. Again, investors have been sucked into the fallacy that recent conditions are certain to persist indefinitely. The equity and credit markets began to show cracks in the last half of 2014 but market indices still managed to persist near record highs. Stock market perma-bulls argue that P/E ratios of cap-weighted indices like the S&P are still below levels hit during the internet bubble. Although widely touted, forward P/E ratios have been an extremely poor indicator of stock prices. Significantly, the median P/E ratio for the average stock is now higher than it was at the 2000 market peak. So far the bubble has shown only small leaks but the risks are extreme.

Unlike every previous bear market for the last 100 years (since the creation of the Federal Reserve in 1914), the safety net under stock prices no longer exists. In past bear markets, banks stepped in to snap up stocks at bargain prices, supported by assurances from the Fed that interest rates would fall until the market recovered. Post-crisis financial regulation prohibits banks from taking the kind of large speculative positions that turned markets around in the past. Additionally, what is a Fed to do when rates are already at zero? Just because the private sector economy is on sounder footing than it was in 2007 doesn’t mean stock prices can’t retreat significantly. In fact, a recent study from Ned Davis Research indicates that the correlation between changes in GDP growth and stock returns the following year is about .01…On a scale from 0 to 1.

A recent retreat in investor sentiment provides fuel for short covering rallies that may or may not result in new token highs but the modest stock market decline that began in January is likely to extend into a full-fledged bear market before 2016. Just as stock prices rose more than 25 times faster than the economy during the last six years, stock prices will fall disproportionately in anticipation of a slower economy, long before the next recession becomes evident.

  • Shorter term there exist a variety of historical market indicators often cited to predict stock market direction in any given year. Almost all of them rely on a statistically unreliable small number of samples and demonstrate correlations that could in fact be random rather than indicating any real cause and effect. Some are interesting and fun nonetheless. Many argue that the third year of the presidential election cycle is usually the best performer (which makes some sense)…these bulls also love calendar years ending in 5. Bearish indicators in 2015 include; New England’s win at the Super Bowl (and what a Super Bowl it was – no matter which side you preferred), the extreme rarity of bull markets lasting more the six years, the January effect (down Januarys indicate down years)…So…take your pick?
  • Major foreign stock markets (Japan & Europe) will outperform the US in 2015. We have already invested a small portion of our portfolio across the Pacific in Japan (FJPNX, FJSCX) but will wait for a further decline in the Euro before committing money across the Atlantic in Europe. Markets in Russia, Greece, and Latin America have collapsed and are having fire sales. We have our toe in the water with a small position in Latin America (FLATX). We’re looking for a good entry point into European shares. Despite potential crises in Russia and Greece, the weak Euro and low energy prices already lifted European stocks about 7% in the first few weeks of the year. Although European shares look reasonable when compared to US stocks, they are not nearly as cheap as Japan and the emerging markets. Japan in particular has made huge investments in the US, which translate into large repatriated profits in Japan. Although these markets are likely to outperform the US, there is still the risk of a brutal leg down in sympathy with a US bear market.
  • Despite (or perhaps because of) the overwhelming consensus that the dollar will continue to rise, I expect the trade-weighted dollar to decline in value later in the year. The US Dollar was the strongest major currency for the 2014 calendar year, but it was upended by both the Swiss Franc and Gold in January. The Japanese Yen may have already bottomed at around 120 yen/dollar, while the Euro may drop another 10%, to dollar parity, before turning around. Current exchange rates virtually assure a massive shift in the trade balance to the detriment of the US. A bigger problem is that being “long” the US Dollar is probably the most crowded trade in history. Any significant Dollar weakness could compound rapidly as speculators try to exit the trade. This is exactly what happened with the Swiss Franc. If you are planning a trip to Europe or Japan, book your summer reservations soon (you might however want to wait a couple of months for airfares to drop).
  • The recovery in gold prices from the 2014 lows has already made the Gold Mining sector the best performer this year. While oil and gold prices often move in the same direction, the percentage decline in oil prices is ten times greater than decline in gold prices during the last six months. We strongly prefer gold miners to the yellow metal because lower energy prices pump up mining profits, even when gold prices fall. Except during short periods when both gold and stocks are simultaneously over or under valued (not presently) the price of gold and stocks tend to move in opposite directions. If declining stocks fuel rising gold prices (as they have since late December), mining profits will simultaneously benefit from rising revenues and lower energy costs. Our largest position (FSAGX) is concentrated in gold miners, which we expect to continue to be the best performing sector of 2015.
  • Unemployment will continue to fall but will likely only provide a small boost to wages. The shift away from growth in oil patch investment, to growth in consumption means we will be hiring a lot of restaurant workers and retail clerks at low wages, while laying off a smaller, but substantial number, of oil workers making the big bucks. One recent employment bright spot has been auto sales and hiring. That sector should continue to do well, but recent subprime defaults and the possibility that a disproportionate number of those fancy pickup trucks were sold to energy company employees could reduce growth. Interestingly, exports from foreign car builders with plants in the US are rising because the US has become a significant portion of their global capacity. Unlike foreign profits of US companies that are suffering from the strong dollar, profits of foreign companies operating in the US benefit. Most of these operations are structured to shift profits and taxes out of the US so the benefit will be limited to job growth. Like jobs and investment, falling oil prices will have divergent impacts on different regions. Our home base in the Long Beach/Los Angeles area will not only enjoy lower prices at the pump, but port activity will soar with Asian imports. Meanwhile our northern neighbors in Kern County (one of the biggest oil producing regions in the country) will see a big jump in layoffs and foreclosures.
  • At the risk of overstating the obvious, the US is likely to experience a brief period of falling consumer prices early in 2015 as the impact of a strong dollar and falling oil prices bite. Unless the next recession hits early, inflation should start rising late in the year after oil prices bottom and the rising trade deficit weighs on the US Dollar. An important note: Owners Equivalent Rent (OER) is 24% of the consumer price index while energy only accounts for 8.4%. Rising rents preclude any persistent deflation, at least until the next recession. In addition, nonfarm worker productivity continued to slide in the 4th quarter at an annualized rate of 1.8%. This means that over 100% of the recent softness in prices is the result of the falling import and energy prices.
  • Falling inflation has driven yields on TBonds with maturities 10 years and longer to new lows. This is temporary, but TBond prices may rise further in a flight-to-quality when stock prices plunge. Although a rebound in rates seems inevitable, everyone (including me) is expecting significantly lower long-bond yield averages in 2015 than we did a year ago. The universal consensus on rates could trigger a big surprise in the form or a big jump in rates should the rebound in inflation prove bigger than expected.
  • Long-term rates have dropped but short-term rates have inched higher. The only direct benefit of falling long-term TBond yields is to reduce the federal deficit. The rest of the economy is only impacted when other interest rates mirror the change in TBonds. However, with most of government debt financed at shorter maturities, any potential deficit reduction when 10yr TBond yields are already below 2% is limited and may be offset by a very small rise in short-term rates.

The interest rates that impact the economy most are what banks charge marginal borrowers (i.e. yields on junk bonds and rates charged to subprime consumers). Unlike TBonds, rates on high yield (junk) bonds have risen significantly in recent months, and will rise further in 2015. Subprime auto loans have boosted auto sales to records in the past year, but defaults are already rising. Look for banks to start charging more soon to cover the loan losses. Mortgage rates are a bright spot that have dropped along with TBonds, but the decline is much smaller and temporary, limiting any positive impact on the economy. The Obama administration is lowering fees and requirements on government-backed loans, which may provide some additional lift to housing. Potentially offsetting those benefits is the drag of Fed rate hikes expected later in the year. Initially those hikes are likely to be modest until the rising trade deficit and a reduction in the growth gap between US and other regions causes the value of the dollar to decline. At that point the Fed may become more aggressive.

In sum, the US economy will continue to (slowly) expand in 2015, but stock prices are headed the other way. I expected the correction to begin in 2014, but anyone who has been following me knows that about 70% of the time my prognostications prove premature. During the last two years, zero interest rate policy (fueling corporate buybacks) combined with margin buying to inflate stock prices (even though most small investors stayed on the sidelines). Just as important, it has left investors without any safe place to hide, (except cash which returns less than inflation). I really didn’t believe the Fed would persist this long with a policy that postpones and aggravates the next crisis. All the while, this policy does nothing to fix the basic problem; too much debt.

Let’s remember that while more debt pumps up economic activity, it is only borrowing that growth from the future. This fact remains true whether we are talking about societies, governments, businesses or individuals. Only after debt has been reduced can rapid growth be restored and sustained. Unfortunately, since rapid growth is the only pain free way to reduce debt, central bankers have been stymied. The other alternatives are either default/bankruptcy or devaluing outstanding debt with higher inflation. Inflation transfers wealth from creditors who have money to debtors who owe money (by paying back debt with cheaper dollars. Central bankers have chosen inflation as the lesser of evils while failing miserably in implementing it. Absent a rise in consumer prices that devalues outstanding debt, central bankers relied on inflating assets prices (which has largely proved ineffective in boosting growth).

Despite big-time margin buying by a few, most households have chosen to pay down debt rather than buy stocks. Fortunately, a stock market decline is likely to have a smaller direct impact on most individuals them than it did six years ago. Unfortunately, the increase in corporate and government debt has more than offset debt restraint by individuals. Servicing these debt costs in a downturn will result in layoffs (as we are currently seeing in the highly indebted energy sector). Even if we avoid a severe recession next time, debt service consigns us to a world of slow growth at best. Any surge in economic activity, like the one we experienced in 2014, will likely be short lived. Although 2015 growth will be slower than I had hoped, no recession is likely before 2016, (unless of course you live in oil country).

A normal bear market correction will likely create many buying opportunities in both domestic and international markets. Current Fed-induced overvaluations in both the equity and fixed income space have prevented us from getting heavily invested at dangerous prices. Extreme bargain hunting is not a requirement for value managers such as ourselves. Although we prefer a good sale, we only require prices at or below fair value for an entry point, which allows for time to do the heavy lifting. As the pieces continue to fall into place indicating our chance is soon, we eagerly await our opportunity to invest across more sectors at reasonable prices.

Clyde Kendzierski

Chief Investment Officer

Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Corporations. The opinions expressed in this newsletter may change without notice due to volatile market conditions. This commentary may contain forward-looking statements and FSG offers no guarantees as to the accuracy of these statements. The information and statistical data contained herein have been obtained from sources believed to be reliable but in no way are guaranteed by FSG as to accuracy or completeness. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and the author believe the information in this commentary to be accurate and reliable, however, inaccuracies may occur.

Investors should consider the charges, risks, expenses, and their personal investment objectives before investing. Please see FSG’s ADV Part 2A containing this and other information. Read it carefully before you invest.

Past performance is a poor indicator of specific future returns. It, however, may be useful in your evaluation of how FSG performs in different market environments. Investors have the ability to achieve results similar to benchmark indices by investing in an index fund or Index-tracking ETF, typically with lower fees.

Past performance of any security is not a guarantee of future performance. There is no guarantee that any investment strategy will work under all market conditions.

There is no guarantee that the investments mentioned in this commentary will be in each client's portfolio.

This material is intended only for clients and prospective clients of the FSG. It has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy.

This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. No mention of any security or strategy should be taken as personalized investment advice or a specific buy or sell recommendation. Please contact FSG to discuss your specific financial situation and suitability.

It is always the intention of FSG to minimize any negative effect on clients. Our success in that effort, however, is subject to unanticipated market conditions. Consequently, past performance does not guarantee future returns

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