“To err is human,” wrote Seneca. “To persist in it is diabolical” (Errare humanum est, Perseverare diabolicum). As 2014 opened, pundits expected interest rates and stocks to go higher, with more certainty about the former than the latter. They also expected the economy finally to turn the corner after five years of sub-par performance. Now that the midway point to the year has been reached and stocks, bonds and commodities have all posted gains together for the first time since 1993, my ongoing and deeply held cynicism about forecasts and forecasters has yet again been confirmed. In other words, be leery about fighting the Fed, fade forecasts and be sure to diversify.
The halftime scoreboard shows that rather than rising 50bp or so, the benchmark 10-year U.S. Treasury note has rallied by roughly that amount while the long-end of the curve has seen double-digit returns. Global bonds as an asset class have performed admirably (FWDB up 6.45 percent) while domestic bonds are nothing to complain about either (AGG up 3.75 percent). Taking on extra credit risk didn’t really pay, as high yield (HYG) advanced 4.96 percent while investment grade corporates returned roughly 100bp more.
Despite historically high valuations, the S&P 500 index has already jumped 7 percent this year and was up for the sixth straight quarter while small caps have lagged (IJS up 4.16 percent). Going overseas didn’t pay, either in large (EAFE up 4.31 percent) or small caps (EEM up 4.54 percent). Utilities (up 18.65 percent) and domestic REITs (IYR up 16.18 percent) were the leading domestic sectors. The worst was consumer discretionaries (up only 0.6 percent, but still up). Obviously, financial market volatility has remained extremely low.
Meanwhile, the U.S. economy was reported to have shrunk by the highest level since the dark days of 2009 last week (GDP off a whopping 2.9 percent, bad weather or no). If that’s turning the corner, I’m mighty concerned about what we’ll find once the turn is complete. The print was so bad that concerns about recession are back on the table. Moreover, the Citigroup Economic Surprise Index, which tracks how various economic data points are faring relative to expectations, has turned down sharply. Other data points aren’t so negative, as jobless claims have dipped, consumer confidence is up to its highest level since 2008, and a classic Monet sold for $54 million, for example. Accordingly, most economists expect GDP to improve markedly in the second quarter.
As one might expect from a maturing economic recovery, Fed policy is in transition. The Fed will likely continue to taper its bond-buying program – designed to drive investors to stocks – by $10 billion per FMOC meeting, which should lead to an exit from the program altogether by the end of 2014, and begin to raise interest rates by late 2015. That schedule assumes that the economy tracks closely to the Fed’s forecast of near 3.0 percent GDP growth for 2014 and 2015, the unemployment rate declines steadily to roughly 5.5 percent, and inflation moves a bit higher but remains modest at around 2.0 percent. However, since a wide variety of Fed forecasts have been wrong pretty consistently, I see little reason to think the Fed’s forecasting ability will suddenly improve. Remember – fade forecasts.
Among the analysts I respect, such as Seth Klarman, Robert Schiller and Jeremy Grantham, most are concerned about stocks, despite calls among economists for 3 percent GDP growth in 2Q (see below), more stock buybacks and ongoing Fed easiness.
But, as ever, fighting the Fed is a dangerous proposition indeed. The cumulative annualized return for the S&P 500 over the last three calendar years has been an astonishing 16 percent and has approached that level so far in 2014 despite an economy that has been tepid at best. That means that money in the market on January 1, 2010 and left there has roughly doubled since. Everybody wants a piece of and nobody wants to be non-correlated to that. Moreover, economic difficulty and stock market weakness are hardly correlated (see below).
Source: Marginal Idea; J. Lyons Fund Management
As a matter of economic (Fed) policy (and in the words of Tomáš Sedláček), we keep shorting stability to try to buy growth. Fiscal policy is a trick, pretending there is demand when there is none. Monetary policy is also a trick, pretending there is liquidity when there is none. Still, we keep pretending (or at least hoping) that the Fed’s new clothes are indeed lovely. It’s bad policy, surely, but there is little reason to try to oppose it with our investment dollars. As Augustine prayed (Confessions, Book 8, Chapter 7): Da mihi castitatem et continentiam, Sed noli modo (a rough paraphrase is “Make me pure, but not yet”). Our investment approach needn’t be consistent with our favored policies. Trick or no, investment returns since 2009 have been both remarkable and real. It’s wise to fade Fed forecasts but fading Fed policies hasn’t worked well.
More specifically, investors with longer-term time horizons can withstand nearer-term difficulty (see below) if, indeed when it happens. It is helpful to recall (as the great investor Peter Lynch pointed out) that far more money has been lost trying to avoid market downturns than in the downturns themselves.
One of the best investment managers out there, Seth Klarman,, who founded the Baupost Group a Boston-based private investment partnership (and whose book, Margin of Safety, sells used for thousands of dollars) , says that we should worry top-down but invest bottom-up. As I have noted consistently in my weekly commentaries of late, there is a lot to worry about in the markets today. Worrying top-down is important because nobody wants to be hurt by some adverse macro, sectoral circumstance. Moreover, the macro environment has to impact the bottom-up analysis – especially as it relates to determining valuation and thus relative value.
But there is still no good way to time the market consistently and investing is required if an investor seeks to outperform inflation and meet longer-term financial goals. Accordingly, in all environments, investors must simply do the best job they can to identify specific, bottom-up opportunities to deploy the available funds. Moreover, the longer the investor’s time horizon, the less important the “top-down” environment becomes. Even so, today’s environment demands caution. I agree with Klarman that the Fed’s adventure into uncharted territory is likely to end badly. What is unsustainable tends to stop. Fantastic deep value investors like Klarman have a long history of being right – but also early. When will this happen? “Maybe not today or tomorrow, but someday,” Klarman writes.
There won’t likely be any sort of signal when the tide finally and inevitably turns. Yet it needn’t be anytime soon either. “Someday: could be a long ways away. Until then, fight the Fed at your peril.