2015 Stock Market Outlook & Forecast

X-factor Report 21 December 2014

by Lance Roberts, StreetTalk Live

“Predictions Are Difficult…Especially When They Are About The Future” – Niels Bohr

We can’t predict the future – if it were possible fortune tellers would all win the lottery. They don’t, we can’t and we aren’t going to try to. However, we can analyze what has happened in the past, weed through the noise of the present and try to discern the possible outcomes of the future.

The biggest single problem with Wall Street, both today and in the past, is that they consistently disregard the possibility for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During that 25 year time frame Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy. Ed Yardeni published the two following charts which show that analysts are always overly optimistic in their estimates.

This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic. Furthermore, the reason that earnings only grew at 6% over the last 25 years is because the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term…remember that.

The McKenzie study noted that on average “analysts’ forecasts have been almost 100% too high” and this leads investors to making much more aggressive bets on the financial markets. Wall Street is a group of highly conflicted marketing and PR firms. Companies hire Wall Street to “market” for them so that their stock prices will rise and with executive pay tied to stock-based compensation you can understand their desire. Currently, there is not ONE estimate for a negative return in 2015. (See Bob Farrell’s Rule #9 at the end of this missive)

Have you ever asked yourself WHY Wall Street spends BILLIONS of dollars each year in marketing and advertising trying to keep you invested at all times?

Since optimism is what sells products, it is not surprising to see Wall Street’s pushing expectations higher as we move into 2015. If they told you that 2015 was going to be a “bad year” would you leave your money invested with them for a fee?

Benchmarking Is The Pathway To Hell

Listening to “fortune tellers” will eventually hurt you. This is why comparing your portfolio to the market is a major mistake to begin with. As I wrote previously:

“Comparison is the cause of more unhappiness in the world than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. ‘Keeping up with the Joneses,’ is one well-known way.

If your boss gave you a Mercedes as a yearly bonus, you would be thrilled-right up until you found out everyone else in the office got two cars. Then you are ticked. But really, are you deprived for getting a Mercedes? Isn’t that enough?

Comparison-created unhappiness and insecurity are pervasive, judging from the amount of spam touting various enlargement procedures for males and females. The basic principle seems to be that whatever we have is enough, until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.

Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with, work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else” made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.”

You job as an investor, and mine as a portfolio manager, is not to beat some arbitrary benchmark index but to insure that you are doing the best thing with YOUR money for YOUR family. Does that mean that EVERY investment will work out as planned? Of course not. However, over a long period of time investment goals can ultimately be achieved.

A Note About Risk Management

Since I understand that not all investments will work out as planned, this is why I focus so much attention on the management of the inherent “risk” of every investment. What the vast majority of investors forget is that greater returns are generated from the management of “risk” rather than an attempt to create returns.

My philosophy was well defined by an interview I did with Robert Rubin, former Secretary of the Treasury, when he said;

“As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide, and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it.

Another benefit of acknowledged uncertainty is it keeps you honest.

“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.”

The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

What Are The Odds Of An Up Year In 2015?

As we enter into the 5th year of the decade what do the decennial trends tell us about the probabilities of stock market returns in the coming year.

In reviewing 2014, we find that the 4th year of the decade has been positively biased over its history turning in an average return of 5.42%. However, the positive return years have outnumbered the negative by 12 to 6.

As shown in the table above, 2015 is extremely “bullish” biased. The average annual return in the 5th year of the decade is a monstrous 21.47%. The 5th year of the decade has a history of large double-digit returns.

However, what may be different in 2015 is that there are only THREE (3) previous periods in history where all three prior years were positive market years. One of those three periods returned a -8.5%.

Nonetheless, the win/loss ratio equates to an 83% probability to further gains in the coming year and as such it is not wise to bet heavily against those odds.

While statistics suggest that 2015 leans more heavily towards positive returns, there is sufficient cause for concern. Global economic weakness, deflationary pressures, high valuations and the potential of the Federal Reserve tightening monetary policy could all throw a wrench into the final outcome.

Help From The Oval Office?

The stock market is also moving into the pre-election year of the Presidential election cycle. With President Obama now a “lame duck President,” the market and economy are going to begin to deal with higher costs and taxes from the Affordable Care Act combined with reduced liquidity from the Federal Reserve. Furthermore, the ongoing debate and drama from Washington, and lack of fiscal policy, will remain present as we head into 2015.

The good news is that the second year of the President’s term has a 75.56% win/loss ratio. Since 1833, the market has been positive 34 out of 45 pre-election years. Furthermore, returns have positively biased as well gaining 10.43% on average.

As you can see in the accompanying table returns during the third year of the election cycle can have wild swings. However, since 1941 there has not been a single instance of a negative return year to date. Could 2015 break that trend? Absolutely. There are certainly enough risks currently to trigger such an outcome.

Furthermore, there have only been two periods where the market was positive in all three of the preceding years which occurred exclusively during the “Tech Bubble” in the late 90’s.

While the odds of a positive year in 2015 are in your favor, one should not dismiss the potential for a decline. Clearly, we are not in a normal economic cycle when Central Banks globally are flooding the system with liquidity to keep prices elevated. The real economy is not supportive of asset prices at current levels, and further elevations in prices increase the potential for a future market dislocation. For investors that are close to or in retirement some consideration should be given to capital preservation over chasing potential market returns.

Rules For The Road

While from a statistical standpoint the odds of an up-year in 2015 are certainly stacked in investor’s favor, this does not mean that a negative outcome cannot happen. When the outlook for 2015 is universally, and to some degree exuberantly, bullish, it quickly brings to mind Bob Farrell’s Rule #9 which states that:

“When everyone agrees…something else is bound to happen.”

Will 2015 be another strong bull market year? Honestly, I don’t know, and anyone who suggests they do is lying. However, as shown by the chart below, the deviation of the S&P 500 from its long-term trend is now the greatest it has been in recent history. The eventual “reversion” to that long-term trend will be an event that you will want to miss. This is why paying attention to the “trend,” and reacting to changes to it, is so critically important.

From a technical perspective the potential for further advances in 2015 are somewhat limited without a significant correction first.

However, as I discussed in “Are We Entering The 3rd Stage Of A Bull Market?”

“In the final phase of the bull market, market participants become ecstatic. This euphoria is driven by continually rising prices but a belief that the markets have become a “no risk opportunity.” Fundamental arguments are generally dismissed as “this time is different.” The media chastises anyone who contradicts the bullish view, bad news is ignored, and everything seems easy. The future looks ‘rosy’ and complacency takes over proper due diligence. During the third phase there is a near complete rotation out of “safety” and into ‘risk.’ Previously cautious investors dump conservative advice, and holdings, for last year’s hot “hand” and picks.”

“It is necessary to remember what was being said during the third phase of the previous two bull market cycles.

• Low inflation supports higher valuations
• Valuation based on forward estimates shows stocks are cheap.
• Low interest rates suggests that stocks can go higher.
• Nothing can stop this market from going higher.
• There is no risk of a recession on the horizon.
• Markets always climb a wall of worry.
• “This time is different than last time.”
• This market is not anything like (name your previous correction year.)”

Well, you get the idea.

MY JOB

I do not have an enviable job. I am not a fortune teller, or a psychic, but investors always want to believe that I know something that they don’t. This is simply not true.

All I can do is analyze as many of the facts as possible so that you can make your own financial decisions as we head into the coming year.

One of my favorite quotes is by Howard Marks and is a principle that I live by:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that “being too far ahead of your time is indistinguishable from being wrong.”)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

As we enter into 2015, it may pay to be a little more cautious after such a large rise in the financial markets. Think about it this way – if you need to grow your assets by 5% per year from now until you reach retirement then 2014 advanced you two (2) years towards your goal. Raising cash and protecting that cushion really shouldn’t be a tough decision. However, not doing it should make you question your own discipline and whether “greed” is overriding your investment logic.

However, such a comment is invariably greeted by the comment: “But if the market keeps going up – I will miss out.”

This is where being a contrarian pays off – as long as you have patience. It is okay to miss out on an opportunity – it is nearly impossible to make up losses. The headlines are rampant at the moment that we are in a new “secular bull market” and “this time is different.”

Ladies and gentlemen – getting back to “even” is NOT an investment strategy. It is a game that has been played out since the turn of the century and investors have lost out on both time and inflation.

The problem for investors is that the 15 years that have now passed to grow and compound your money for retirement is GONE. You can never regain that time. Sure you can work 16 years longer but you will never achieve catch up to the time that was lost.

While the financial press is full of hope, optimism and advice that staying fully invested is the only way to win the long term investing game; the reality is that most won’t live long enough to see that play out.

Being a contrarian is tough. However, sitting on the sidelines when the herd is running to the edge of the cliff is a strategy that will always win in the long term because buying “distressed” and selling “dear” is a strategy that always works.

When In Doubt Always Refer To Bob Farrell’s 10 Rules:

1. Markets tend to return to the mean over time
2. Excesses in one direction will lead to an opposite excess in the other direction
3. There are no new eras — excesses are never permanent
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
5. The public buys the most at the top and the least at the bottom
6. Fear and greed are stronger than long-term resolve
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
9. When all the experts and forecasts agree — something else is going to happen
10. Bull markets are more fun than bear markets

There will be no X-factor report next week.

Wishing you a Merry Christmas and a happy and prosperous New Year.

Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer at the bottom of this report.