12 surprises for 2015
“Unlike, say, meteorologists, who predict specific outcomes at exact times and use percentages to indicate how confident they are about their forecasts, financial pundits rarely assign probabilities to their predictions and make a variety of judgment calls that can be hard to categorise.
“Why, then, do so many people seem to complain that the weather forecast is inaccurate even as they bet a chunk of their life savings on a prediction from an investing pundit whose track record isn’t even traceable?
“Humans don’t want accuracy; they want reassurance. The Nobel laureate and retired Stanford University economist Kenneth Arrow did a tour of duty as a weather forecaster for the US Air Force during World War II. Ordered to evaluate mathematical models for predicting the weather one month ahead, he found that they were worthless. Informed of that, his superiors sent back another order: ‘The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.’
- Jason Zweig, “Lessons from a Year of Market Surprises”, Wall Street Journal December 30, 2014
I’m pretty sceptical about the predictive power of most things, especially when it comes to any aspects that involve human emotion or a collective social conscious. Personally, I prefer to study businesses and companies and assess their value and likelihood of various scenarios than burn hours pondering the direction of markets.
Finding great investments often does not depend on guesses about the economy, interest rates, etc. January is the month where almost everyone in my industry has an opinion. To be right in predicting, the saying goes, is to predict often. In fact it’s hard to know how well many prognosticators do because their “predictions” are constantly changing. For the most part, however, it’s your job as an investor to ignore pundits and their forecasts. Many famous forecasters are simply guys/gals who have gotten one prediction right in a row.
I’ve said this in all prior surprise columns and I’ll say it again; forecasting is pretty much junk. Situations in financial markets are fluid, thus all prognostications are almost instantly stale. Trying to guess what the market will do next is like trying to nail Jell-O to a tree.
No one can truly claim with certainty that they know what tomorrow will bring and if you meet someone who does you should put your hands in your pockets to check for your wallet and slowly back away. Voltaire sums it up best: “Doubt is not a pleasant condition, but certainty is absurd.” Besides, successful investing involves following the right principals NOT the right predictions.
The term ‘surprise’ means an unexpected event that is currently an out-of-consensus view. I have tried to list a few outcomes that I think actually do have a chance of happening but are not really expected because they are under-recognised probabilities or very contrarian. I have written these in the spirit of nudging the reader to look “outside-the-box” and consider a disparate view of things that may cause some cognitive dissonance.
I also have included investment vehicles or strategies where appropriate to track aspects of these calls (see important disclaimer at the end). It’s worth noting that this year has felt like the most difficult year to collate surprises.
The world appears to me to be in a major transitory state full of dissenting macro forces. This would suggest my confidence in these surprises is very low. To be clear, what follows is NOT an investment strategy but a list of potential surprises for 2015.
1 Curb your enthusiasm. The surge in positive economic flow from the America’s Cup investment and tourism build is overwhelmed by the contraction in Bermuda’s biggest sector. The combination of alternative capital is changing the value proposition of traditional reinsurance. This simply means that the world needs for reinsurance are changing rapidly. This in turn means that existing players will fight harder for the shrinking traditional pie, and attempt to expand into new lines (eg assumption of government insurance roles, cyber-risk, etc). It also creates an environment where primary companies will feel even greater pressure to buy cheaper reinsurance. XL felt their best option was to do a near-term book value dilutive deal in order to accelerate growth in an environment where scale is seen as needed. The XL/Catlin deal only accelerates consolidation which leads to even more contraction in jobs for the reinsurance sector and associated contraction in commercial real estate space, support industries and higher paying jobs. The Bermuda economy waffles around zero and GDP remains flat in 2015 despite the large boost from bodies brought in for the American Cup and the beginning of new hospitality projects.
(Bonus thought: Cuba’s awakening also begins sucking up marginal tourism dollars pressuring traditional island vacation locations)
2 Monopolies don’t trade at under 20 per cent of book value? Ascendant (AGL BH), the holding company that controls Belco, looks dirt cheap and investors realise it. Companies that are the only game in town with virtually no competition don’t deserve to trade at 17 per cent of book value. Especially when they pay you a tax free yield of 5.7 per cent. Stabilising levels of power consumption and lower overall expenses boost earnings and the share price. LNG plans are scrapped in favour of purchasing more efficient diesel generators. They even consider a hedging programme (for the benefit of the nation) to dampen Bermuda’s volatile exposure to energy prices.
Strategy: Buy Ascendant Group (Ticker: AGL BH)
3 Digicel/BTC buys World on Wireless (WOW). The telecom space continues to consolidate in Bermuda. Digicel/BTC (who has no TV rights) acquires WOW for the TV rights and the ability to offer the “triple play” to consumers.
4 The Federal Reserve blinks. The Fed continues to make noises about ‘normalising’ monetary policy, but ends up doing virtually nothing. At most, there is a single 0.25 per cent rate hike for 2015. The now dovish majority channels fears that economic weakness elsewhere in the world, primarily the euro-zone, will weigh on the US economy and the absence of obvious “price inflation” problems slow the pace of normalisation.
5 Yields fail to rise — again. US Treasury yields defy the majority view by ending the year flat-to-lower. More specifically, the 30-year T-Bond yield is roughly unchanged over the course of the year. Interest rate differentials in favour of US Treasuries keep the market well bid and lower global yields keep the market anchored.
Strategy: Buy iPath US Treasury Flattener ETN (Ticker: FLAT)
6 Gold glitters. Gold defies the numerous calls for a flat to down year. Gold’s bullish trend is driven by declining confidence in central banking (and currency wars) and rising concern about various geopolitical ‘tail risks’. It may also benefit from a dollar rally stall. This coupled with much lower energy costs boosting gold mining margins.
Strategy: Buy Market Vectors Gold Miners ETF (Ticker: GDX)
7 The S&P 500 Underperforms. Strategists estimate the S&P 500 will end up eight to ten per cent on average. The S&P 500 begins the year with a price/earnings (P/E) multiple of about 18 times trailing 12-month earnings per share. This represents a valuation higher than about 74 per cent of the time since 1945. The median New York Stock Exchange stock is currently at a postwar record high P/E multiple, a record high relative to cash flow, and near a record high relative to book value. This valuation headwind more than offsets any earnings growth. The S&P 500 likely ends the year with a negative sign in front of its return. Stock picking becomes paramount.
Strategy: Short or avoid the SPDR S&P 500 ETF (Ticker: SPY)
8 What was real bad becomes good. A tentative peace and conciliation agreement is reached between Europe, the Ukraine and Russia. Sanctions are eased and energy prices stabilise. The Russian currency (the rouble) and stock market bottom out during the first half of the year and end 2015 with net gains. Greece does NOT leave the EU. The Syriza’s rise doesn’t derail Europe and Greek equities rise.
Strategy: Buy Market Vectors Russia ETF (Ticker: RSX), buy Global X FTSE Greece 20 ETF (Ticker: GREK)
9 Greenback gives some back. What “everyone knows” is usually unhelpful at best and wrong at worst. Everyone “knows” the dollar will rally. The strength in the US dollar has truly been a case of it being the cleanest dirty shirt in a very dirty laundry basket. Traders are more bullish toward the dollar than any time since the peak of the tech bubble in the late 1990s. The euro-zone is on the verge of commencing significant easing measures to try to jump-start their collective economies, and Japan is in the midst of a mind-boggling quantitative easing experiment designed to shake off a multi-decade stagnation. Looking ahead, nothing on the horizon would suggest the dollar is going to do anything but get stronger. What if the European Central Bank’s quantitative easing (QE) programme proves disappointing, the European bank deleveraging reverses which leads to slightly higher growth in 2015 and traders focus on Europe’s record current account surplus? What if one focuses on the decline and energy prices and the slow restart of Japan’s nuclear plant that lead to net improvements in the net trade balance for Japan? It would be a very big surprise indeed to see the yen and euro end the year higher versus the dollar.
Strategy: Short the DXY Index
10 Short Canadian banks. Most people easily grasp the immediate impact of developments, but few understand the second-order consequences. These additional factors or often coined contagion effects when they alter assets prices. The collapse in energy prices clearly are a negative factor for the Canadian economy. The Canadian banks face significant headwinds moving forward as well. Too many analysts spend their time discussing the trees, when really they should step back and evaluate the state of the forest when it has begun to burn. Looking at the Canadian forest, things are not really great. Commodity prices are collapsing, global economic growth is lacklustre, interest rates are falling, the yield curve is flattening, the loonie is getting smoked, the housing market is overstretched, the Canadian consumer has more debt today than the average American had before the 2008 credit crisis. To top it off analysts have insanely lofty expectations regarding the banks’ earnings. Against this backdrop, Canadian banks continue to trade close to all-time highs. It is very difficult to measure the second-order impact that the natural resources sector has on the Canadian economy. Think of all the auxiliary business activity associated with natural resource development, production and transportation. This would feed through to many different sectors of the economy like trucking and transport, various industrials, engineering companies, construction companies, law firms, housing and financial service companies; to name a few. This is negative for the overall economy, jobs and housing, and, as a result banking.
Strategy: Short BMO S&P/TSX Equal Weight Banks Index ETF (Ticker: ZEB.CN)
11 Alternatives outperform. Hedge funds have underperformed a 60/40 portfolio for every year over the last decade. Since 1998, hedge fund managers have taken about 84 per cent of total returns as fees with only 16 per cent going to investors. The large Dutch pension fund PMT and CalPERS have decided to pull out of hedge funds all together. Hedge fund closures accelerated last year amid increased costs, lacklustre performance and investor preference for giving money to the largest firms. A Hedge Fund Research Inc report this month showed 661 funds shut down in the first three quarters of 2014. Ironically nothing could be better for the industry than massive redemptions and far less capital. Rising volatility and intra-asset class dispersion leads to opportunities for active managers and alternative stewards of capital.
Strategy: Buy a hedge fund and alternative basket consisting of Och-Ziff Capital (Ticker: OZM), Blackstone Group (Ticker: BX), KKR & Co (Ticker: KKR), Third-Point Re (Ticker: TPRE), and Greenlight Capital (Ticker: GLRE).
12 European energy. Everyone hates Europe and everyone hates energy. Sounds like an opportunity to me. The European stock market is currently trading at 38-year price lows relative to the US. Over 80 per cent of the world market capitalisation is currently supported by zero interest rate policy (ZIRP), more than 50 per cent of all government bonds in the world currently yield one per cent or less, Swiss bond yields out to ten-years are negative, and about €8.5 trillion of bank deposits in Europe earn effectively nothing. Europeans need to find yield! One option is to look at buying large-cap, defensive, high-dividend yielding energy stocks in Europe. Unloved European energy is trading at record valuation lows (price-to-book) versus US energy; the sector’s dividend yield is now over 5.5 per cent.
Strategy: Buy SPDR MSCI Europe Energy ETF (Ticker: STN.FP)
Cyber warfare. The estimated number of cyber-attacks per week is about 122,000. Last year major attacks were made on eBay, Home Depot, JP Morgan and Target. The average successful cyber-attack is estimated to cost $12.7 million per US company this year and cybercrime costs the global economy an estimated $0.5 trillion annually (source: CSIS, McAfee). 2015 sees a major attack on a US bank and retailer. Companies get serious on investing in protection.
Strategy: Buy PureFunds ISE Cyber Security ETF (Ticker: HACK)
Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Mr. Kowalski and/or clients of Anchor Investment Management Ltd. hold positions in GDX, GLRE, TPRE, BX, AGL.BH.