Financial Markets 2015 Outlook

By: Money_Morning

Michael E. Lewitt writes: For the first time since 2008, stocks traded down on the last trading day of the year and the first trading day of the New Year.

Whether this will prove to be a mere statistical curiosity or a harbinger of troubles ahead remains to be seen, but there are enough headwinds facing investors to force them to don foul weather gear for the year ahead.

Markets are likely to see heavy seas in 2015 as the Fed starts raising interest rates and oil prices stay lower for longer than anybody expects…

The Oil Spill is Spreading

The biggest headwind – and the biggest story in financial markets in 2014 – is the collapse in oil prices.  Oil dropped by 46% over the second half of the year as observers debated whether oversupply or dropping demand was the culprit. Suffice it to say that the price of the world's most important commodity does not drop by nearly 50% over six months without severe demand problems.

The global economy is suffering from slow growth in every region outside of North America. China is growing at less than 5% despite phony statistics that say otherwise; Japan is mired in terminal deflation and slow growth; Europe is in recession; Latin America is a basket case; and even U.S. growth is struggling to reach 3%.

No doubt oil supplies were high as a result of fracking and new supply from Libya and Iraq, but the real culprit in the price drop was a global economy that is still ailing six years after the financial crisis. Futures markets are currently pricing in even lower prices in the first quarter of 2015.

By the Numbers

None of this stopped U.S. stocks from enjoying another year of double-digit gains in 2014. The Dow Jones Industrial Average gained 10.04% while the S&P 500 added 13.69% and the Nasdaq Composite Index moved up 13.4% and is within spitting distance of its all-time high reached during the Internet Bubble in 2000. The small cap Russell 2000 added 4.89% last year. Stocks ended the year at extremely extended valuations. The S&P market cap/GDP ratio (1.27 versus mean of 0.65) and the Shiller CAPE ratio (27x versus a mean of 16.6x) tell the story of an overvalued market.

Stocks are trading at 16x forward earnings compared to a norm of 14x, which may not seem excessive until you consider that earnings are artificially inflated by massive stock buybacks, low interest rates, wage suppression, phony stock option accounting and other factors.

None of this seems to bother investors, but it should. They remain, however, complacent as they maintain blind faith in the ability of the Fed to keep lifting stock prices. The CBOE Options Exchange Volatility Index (VIX) averaged 14.17 over the course of the year, down from 14.23 in 2013 and less than half the level in 2009, the first year of the bull market.

Investors should expect it to be higher in 2015 as the Fed starts raising rates and the consequences of lower oil prices start to be felt. Call it the calm before the storm but when complex systems such as financial markets experience unusually low levels of volatility for long periods of time, they tend to grow increasingly fragile and susceptible to bouts of instability.

That is now the case with the stock market. Investors have demonstrated extremely low tolerance for bad news or surprises. The near-hysterical reaction of the stock market in mid-December to Janet Yellen's promise to be "patient" before raising interest rates in 2015 should be seen as a symptom of just how intolerant markets are likely to be when the Fed finally pulls the trigger and takes the long overdue step of raising rates. Having just pumped up the Dow by 700 points after her promise, one has to wonder how quickly investors will start selling their stock after they realize that the Fed's patience has run out.

In non-US markets, the Stoxx Europe 600 gained 4.3% while the MSCI Emerging Markets Index lost 4.6% in 2014. Emerging markets began to feel the effects of the strong dollar in 2014, but things will get much worse for them in 2015.

Russia's Micex Index lost 7.2% as the ruble collapsed by 44% last year against the U.S. dollar; apparently Vladimir Putin didn't win in the Ukraine after all. His economy is now in a shambles. Investors may begin to pick among the ruins of Russian stocks in 2015 but they should proceed with caution as there is little prospect of a quick recovery.

As noted above, currencies played a big role in 2014 as the dollar rose sharply against the euro and the yen. Monetary policy in the U.S. is diverging from the steps being taken by the ECB and Bank of Japan to bolster the still weak European and Japanese economies, sending the regions' currencies in opposite directions.

The Bloomberg Spot Dollar Index rose 11% last year, its biggest gain since 2005. The euro closed on January 2 at $1.2002, its lowest level since June 2010. Further weakness is a certainty. The yen closed at 120.5, significantly lower than its 2014 high of 100.76 as the Japanese government continued to weaken its currency in a desperate attempt to right a sinking economic ship.

Further weakness is a certainty here as well. A strong dollar may be a case of "be careful what you wish for" for U.S. stock investors, however. A significant percentage of S&P 500 earnings come from offshore, so a stronger dollar will negatively impact results. Further, the idea that the U.S. can decouple from weakness elsewhere in the world has long been discredited. We may be the best house in a devaluing neighborhood but sooner or later the drop will arrive at our front door.

Yields Head to Record Lows

Bonds also produced respectable returns in 2014 as interest rates surprised many people by falling significantly due to two factors: weak global growth and high demand from central banks monetizing their debts and private sector banks bolstering their capital bases. Both trends are likely to continue in 2015. The Barclays U.S. Aggregate Bond Index rose by 5.97%; the Barclays U.S. Government Bond Index added 4.92% and the Barclays High Yield Bond Index even eked out a 2.5% return after giving back much higher gains during the fourth quarter as the energy bond complex collapsed.

The yield on the benchmark 10-year Treasury bond ended the year at 2.17%, down substantially from where it started the year at 3.03%. Despite the fact that the Fed ended its quantitative easing program in October 2014, the long end of the Treasury curve is likely to move lower in 2015 on the back of weak global growth.

The short end of the curve moved higher at the end of the year, with the 2-year Treasury yield rising sharply in December to end last week at 0.625%, almost double what it had been earlier in the month. A year ago I thought it would be surprising if the 10-year yield ended the year closer to 2% than 3%. Today, it would be more surprising if the 10-year yield ended 2015 at closer to 3% than 2%. We could test the modern era low of 1.38% hit in 2012 if current trends stay in place. Investors counting on higher long-term rates are likely to get hurt.

Get Your Hedges in Place

Deflationary signals are flashing red around the world. For example, at year-end, German 5-year bonds were trading at negative yields for the first time. Spanish and Italian 10-year sovereign bonds yields were trading well below 2% as investors wait for ECB President Mario Draghi to pull a quantitative easing rabbit out of his hat (hint: whatever he does won't revive European growth). The yield on 10-year Japanese Government Bonds had collapsed to 0.31%.

That message was further reinforced by the bloodbath in the commodities markets. Oil was not the only commodity to drop in price in 2014. All major industrial commodities ended the year considerably lower than they started as demand from China fell off considerably. Combined with sharply lower bond yields, lower commodity prices are telling a completely different story than the S&P 500. The decoupling between stocks and bonds/commodities is something to watch in 2015. Stocks can only defy the deflationary message being flashed by bonds and commodities for so long.

One would think that investors would look around and conclude six years after the financial crisis that monetary policy has failed to ignite economic growth and that another course needs to be followed (i.e. radical pro-growth fiscal policies).

Instead, they continue to pray to the Central Bank gods and hold on to overvalued stocks. There is no question this strategy will not end well, the only question is when, which is why I have written repeatedly they should be hedging their equity portfolios before it is too late.

Source : http://moneymorning.com/2015/01/04/the-early-read-on-2015-markets/

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