30 Jan

The Tale of Two Markets

As Charles Dickens wrote in his epic novel, A Tale of Two Cities: "It was the best of times, it was the worst of times....."

There is no shortage of market pundits expounding their views about prospects for the financial markets. This is nothing new, and one can cherry pick data to support just about any thesis or rational. 

For example, take the "gold bugs," who claim gold is the only real asset that will protect wealth from the ravages of inflation. They believe that central banks' current policies will lead to inflation and the loss of purchasing power as faith in paper currencies is questioned. During the past three-and-a-half years, gold has declined approximately 35 percent in U.S. dollar terms, while the Fed and other central banks pumped unprecedented amounts of money into the banking system. Though they ultimately might be correct in their assumptions, the exact opposite has occurred to date.

As we review 2014 and look ahead, we analyze what "markets" are saying about the future and draw two different expected outcomes. Given what the two markets—bond (fixed income) and stock (equity)—are telling us, it is impossible to fathom that both can be right. The more plausible outcome is that they are both somewhat wrong and the truth lies somewhere in between.

In evaluating the bond market, we look to the U.S. 10 Year Treasury note, which is currently yielding less than 2.00 percent. As paltry as this return appears, consider that similar term sovereign debt from the United Kingdom yields 1.50 percent, Japan offers 0.20 percent, and Switzerland yields -0.10 percent. That minus sign is not a printing error—one pays Switzerland to hold money for 10 years. If the U.S. dollar continues to appreciate against these currencies, these nominal returns will be wiped out. We interpret this to mean that bond participants not only expect zero inflation but have priced in deflation and economic contraction over the next 10 years.

In the equity markets, the price of a stock at any given time measures future earnings and risk expectations. In examining current valuations, we come to a different conclusion. Excluding energy companies, earnings and operating cash flows from U.S. companies are expected to grow approximately 8.00 percent in 2015 from record levels achieved in 2014. Even though expectations have recently declined, this growth rate can support current stock prices.

In addition, the recent decline in energy prices stimulates the U.S. economy. With nearly 70 percent of the economy based on consumer consumption, lower fuel prices and a strong job market should firm up the consumer segment during the ensuing quarters and years. Even though economic growth is slowing in other parts of the world, U.S. growth may very well propel other economies out of their doldrums. Record low interest rates also are likely to support global growth too.

So, how do we interpret this contradicting data?

At EPIQ, we side more with the bond markets. Although, we don't attempt to predict interest or currency rates, we anticipate that the U.S. dollar will continue to appreciate modestly against other major currencies. This will help keep a lid on energy and commodity prices for now.

Over the next year or two, oil prices are likely to move higher. Our opinion stems from limited, low-cost oil production available to supply global markets. Higher prices will be needed to stimulate replacement production. In the short-term, however, we can enjoy near-generational, low-fuel prices because the market is temporarily over supplied. The market, as it always does, will self-correct.

As for equities, we continue to view the U.S. as the most attractive place to invest, with the understanding that global markets are now more interconnected than ever. We project modest earnings growth but do not expect valuation multiples to expand, leaving us with muted expectations for returns. We envision that dividends may provide a significant portion of total returns for the next year or two.

With challenged expectations for constructive returns in public markets, we look to private investment alternatives that potentially offer superior returns, such as real estate or partnerships that invest in other types of illiquid assets. The premium for illiquidity remains significant and offers investors an opportunity to benefit in today's environment.

Although we have muted short-term expectations, it is essential to remain invested. Even more importantly, one must clearly define objectives and understand the risks inherent on the path toward achieving those goals. It is always fun to dream, but in this atmosphere, we feel it more practical to have low expectations for future returns and be pleasantly surprised with better results than the other way around.

Please contact us to continue the conversation. Best wishes for a healthy and prosperous 2015!

EPIQ Partners

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One of our own is being recognized.  We congratulate Bruce Langer for being named a finalist in the Good Leader category for the Community Impact Awards presented by Minnesota Business Awards (http://minnesotabusiness.com/finalists-announced-2015-community-impact-awards).  Way to go Bruce.

 

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