- The U.S. economy should continue to expand and that bodes well for stocks
- The next bear market will likely start due to a recession or geo-political conflict and not from the start of Fed interest rate increases or time elapsed
- The current economic landscape is favorable to growth
- Stock markets are priced for low returns
- We do not own the stock market, but 17 well-researched, individual companies
- We still expect double-digit returns from our portfolios
Despite six consecutive years of positive returns in the current bull market, we likely have further to go. Historically, the U.S. stock market has provided positive calendar-year returns about 75% of the time. Said another way, the U.S. stock market has fallen in about a quarter of the years since 1926. Most declines—about 80%—were accompanied by recessions. Those that weren’t can be counted on one hand.
In 1962, markets declined 9% for no apparent reason. Edwin Posner, then head of the American Stock Exchange, attributed the drop to an adjustment from the previous 10 years of economic growth. In 1966, the Federal Reserve tightened monetary policy to curb too much loan growth and unintentionally created a short-lived credit crunch that caused a double-digit decline. In 1977, the Fed raised interest rates to combat inflation and stocks fell. In these instances, no recession occurred and markets quickly recovered lost ground and made new all-time highs.
Recessions are bred amidst excess and greed. Employment, housing construction, auto sales, and corporate profits grow for a number of years—usually with the help of cheap or cheapening credit—and reach unsustainable levels. Investors believe the good times won’t end and equity market valuations reflect all the excitement. The Federal Reserve inevitably tries to manufacture a soft-landing by raising interest rates. Their hope is that higher rates will slow inflation, deter further excessive risk-taking by businesses, consumers, and investors, and hopefully rebalance the economy without inflicting major harm. In most instances (the exceptions being the 1960s and early 1990s), Fed tightening campaigns have eventually led to recession.
Because the Fed may start to raise rates this year (September at the earliest, in our opinion), there are some that have suggested a bear market in stocks is imminent. Though, Omega Advisors’ Leon Cooperman pointed out in a recent Bloomberg interview that stock markets have, on average, continued to rise for 29 months after the Fed begins to tighten monetary policy. He also noted that the shortest period of further market gains after the first rate increase was 10 months. That suggests a market peak in the summer of 2016 at the earliest. If a fall 2015 rate increase is followed by the 29-month average of further gains, stocks would rise through February 2018.
Of course, this type of reasoning is prejudiced by availability bias, a term psychologists use to describe how our brains err by judging the likelihood of an event on how readily available information is to us. In his book Thinking Fast and Slow, Daniel Kahneman quoted economist Howard Kunreuther: “As long ago as pharaonic Egypt, societies have tracked the high-water mark of rivers that periodically flood—and have always prepared accordingly, apparently assuming that floods will not rise higher than the existing high-water mark.” We researched Mr. Cooperman’s data and he’s right: stocks have, on average, kept rising for 29-months after the first rate hike and 10 months was the shortest period. But those historically accurate monthly figures, the high-water marks of that data, may no longer be relevant. And just as important, the interest rate increases of the 1960s and early 1990s didn’t lead to recession. The point is, we can’t use the start date of Fed policy normalization alone to predict when the market rally will end or when the U.S. economy will go into recession. Though, it is useful to know that—historically—not all rate increases have led to recession and the ones that did took significant time before recession occurred.
Others are arguing that the current bull market in U.S. stocks is set to shortly end due to time itself. If the stock market rises in 2015, the current streak of positive calendar-year returns (starting in 2009) will be the third longest in history, behind the eight year run in the 1980s and the nine consecutive years of the 1990s. Length of bull market is correlated to a higher chance of its end, but time elapsed doesn’t cause anything.
Markets, like matter, appear to be governed in a way similar to Newton’s first law: an object in motion will stay in motion unless acted upon by an opposing force or forces. Central banks, recessions, and geo-political conflict can cause market declines—the arbitrary passing of time cannot.
Which brings us to the following chart:
Above is a visualization of the concept of various forces and their positive/negative effect on U.S. stock markets since 2009. As we discussed above, 80% of the time that U.S. stock markets have declined it was due to negative forces emerging to push the U.S. economy into a recession. Today, housing and auto sales are continuing to recover, corporate profits are expanding, monetary policy is extremely loose, interest rates are the lowest in history, credit spreads are average, inflation is low, and fiscal policy is no longer a strain on growth. If you were trying to create an environment to spur economic growth, today’s condition would be a fairly good effort.
Despite today’s favorable economic landscape, it doesn’t feel that great. People have been calling for the demise of this bull market for almost six years. And that is additional good news: we don’t have the widespread euphoria that has accompanied other market tops. On the negative side, stock markets largely reflect the positive economic landscape and therefore long-term expected returns for stock market indices are scant. But yet we sleep well at night. Why?
We don’t own the stock market. We own a relatively small number of carefully selected, individual companies. We’re thorough in our research and have a repeatable, risk-aware process that should serve us well across this and other market cycles.
Looking back over 2014, it largely played to script. We wrote in January of last year:
“As for 2014? Our best guess is that equity markets will rise again as the economy continues to grow and operating margins expand in the latter portion of this economy cycle.”
“So long as the economy continues to expand, markets may well rise another 20% to 30% over the next two years in this scenario.”
Black Cypress returned 12.7%, net-of-fees, in 2014.
The three largest contributors to 2014 performance were Lowe’s (returned 43%), Apple (41%), and Berkshire Hathaway (27%). The three largest detractors were Exxon (-8%), Chevron (-6%) and General Electric (-3%). Cash held for future opportunity cost us 1.2% of return.
Our firm has compounded our original investors’ capital an average of 20% a year for nearly six years. We’ve outperformed the broad stock market, mutual funds, and hedge funds since inception.
As noted above, we like how we’re positioned for 2015. We own just 17 companies, all of which are deeply researched. Each, in our opinion, is priced to outperform the broad equity market and, in aggregate, to provide double-digit annual gains. And if the positive economic forces shift, our risk management practices, which have been largely unnecessary to date, should be aptly rewarded.
May the force(s) continue to be with us in 2015.
This letter was also featured @ Seeking Alpha, Advisor Perspectives, and ValueWalk.
This material contains the current opinions of the author but not necessarily those of Black Cypress and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without proper reference. Past performance is not a guarantee and may not be a reliable indicator of future results. ©2012, Black Cypress Captial Management