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Potential Market Patterns for 2015

Continuing on our series of forward looking wild speculations about 2015, this update will be about timing and possible price patterns.  Clearly, this is reckless and meaningless when it comes down to it, as conditions will always change making forecasting look silly.  As they say, forecasts are for show, trades are for dough… on with the show.

Signs of an Intermediate Term Top Developing

The crash in oil or the Russian Ruble or the Greek market will not by themselves be the catalysts for a market top in the US.  However, they do provide a higher level of instability and have some dislocating effects on other countries, asset classes, etc.  For instance, clearly we have seen a ton of downward pressure on the US corporate high yield market due to their 15% exposure to bonds issued by oil and gas companies.  But even without this exposure, high yield corporate bonds peaked all the way back in July before any of the oil price carnage.  Failures in peripheral markets do create some higher volatility for our primary markets but they are not by themselves large enough issues to change the long term primary trend of the US stock or bond markets. 

There are other more serious signs, however.  In the last 6 months we have seen the yield curve in our own domestic bond market flatten substantially.  To be clear, the curve is not yet flat but moving in that direction.  An actual inverted yield curve tends to lead most major stock market tops by 2-3 months and is indicative of a pending recession.  I don’t see an inverted yield curve until later in 2015 but it is a warning flag of sorts.

Small caps and High yield bonds are canaries for our domestic stock market and we are seeing clear and present danger signs here.  I am hopeful, almost expecting, these two groups to break out to new highs either this month or in January effectively eliminating this concern but until then, our Net Exposure analysis really won’t let us get more aggressive with our positions. 

The Federal Reserve is also not going to be in a real hurry to raise rates but neither are they promising to be as accommodating as anytime in the last 6 years.  The threat of a rising Federal Funds rate is now with us and the short end of the yield curve is reflecting that risk.  For long dated bonds it’s just the opposite.  Here again, we have some massive external influence (foreign buyers) driving our long bond market to absurd price levels.  They must be in a great deal of pain (and fear) to consider investing massively in US bonds paying 3% interest annually paid for with foreign currency that is losing 8-10% on exchange to USD.   If I were the Federal Reserve, I would dump some of the massive inventory of Treasury bonds now and let the rest of the world carry the risk in what would be the most incredible (and lucky) trade benefiting US tax payers of all time. 

Finally, we must note that Index Mania is with us again and sadly it tends to appear within a few months or quarters of a significant market peak.  As individual sectors, one by one sell off, we are often left looking at the broad market indices as the last man standing and thus deserving of all of our investment capital.  Buyer beware! Jim Stack of Invest Tech did an excellent job noting the Index Frenzy headlines at major market peaks (1999, 2007 and now again in 2014?).  These headlines tend to be a little early but not by much.  Take a look.

"Saving For Retirement" – Index Fever Fortune Magazine – 11/1998

"Who Needs a Money Manager?" - Business Week  2/1999

"Index funds help you avoid risks of stock selection" – Boston Globe 2/2007

"Index Funds: So Hot Right Now" – Motley Fool 12/2006

"Owning the S&P 500 is Cheap, easy and smart" – USA Today 7/2007

And now…

"30 Reasons to fall in love with index funds" – Market Watch 6/ 2014

"Vanguard Balloons as Investors Flock to Index Funds" – Barron’s 8/ 2014

"Investors Flocking into index funds; Here’s Why" – CNBC 11/2014

Possible Pattern for 2015

Here’s my guess as a long as you don’t hold me to it.  I think there is a reasonable chance that the US stock market will finish near it’s highs of this year starting a rebound right here, right now.  If there are not too many international disruptions, the melt up rally could carry into the first few months of the year but with a higher degree of weekly volatility than we have seen in recent past.  Once oil inventories fall by March and oil begins to rebound smartly, all the consumer good will (and extra earnings) generated from cheap gas will go away leaving us with a set up for an intermediate term market correction from higher valuation levels.   From here we could easily see a 20+% decline in the US stock market before summer time 2015, erasing all of 2014 gains plus some of 2013’s gains.  Our intention is to be ready to cut equity exposure, play defense and shift to non-correlated alternatives in the first part of 2015 depending on what happens.


But I don’t see this deep correction event being the end of this secular bull market.  In fact, if the US economy can avoid recession, I would view such a deep correction as a very rich opportunity to buy cheap stocks within a longer term global economic recovery.   We might then find ourselves picking up VERY cheap technology, basic materials, industrials, commodities, energy companies and inflation hedges and re-engaging with some emerging market exposure (discussed last week).   If we don’t see some expansion in the P/E multiples for stocks in the next 3-5 months, we could see it happen on the other side of the deep correction. Valuation guys suggest that S&P 500 index at 2300 would put us at a similar extreme valuation high as other bull market peaks based on current earnings.  So I still think this secular bull market has longer to run beyond an early 2015 correction.    My gut feeling is that there is just too much cash sitting on the sidelines and the secular bull market won’t end in earnest until a majority of this cash is put to work.  The US is also (still) the best looking horse in the glue factory so we have the added support of international investors as well.  We will plan to aggressively buy any significant discount in stocks in 2015.  

Coincident with the bottom of the deep stock and commodities correction in mid 2015, I see a top (permanent) in the US bond market.  This will be another great moment to cut or eliminate bond exposure, perhaps your last.  Heed the signs, avoid assumptions and be ready for some higher volatility in 2015.

Have a great week as you prep for the holidays

Cheers

Sam Jones