Reviewing 2014 through the eyes of RBA
December 7, 2014
Richard Bernstein is a portfolio manager and widely known and quoted market strategist. Prior to founding Richard Bernstein Advisors, Rich was Chief Investment Strategist at Merrill Lynch & Co, leaving in 2009 to start RBA.
Rich is also a valued partner to Redwood. He is the portfolio manager to the Redwood Global Equity Strategy Class, a unique global equity fund, based on RBA’s top-down investment approach.
Recently, Rich and his former colleague David Rosenberg, sat on a panel and presented to a group of investment advisors in Toronto.
You can find the video contents of that presentation here: Rich and Rosie Lunch
For the past number of years, Richard Bernstein Advisors has made predictions for the year ahead. While we await this year’s edition, I wanted to review his “10 for ‘14”.
Rich and his team have shown a real talent for predicting themes at different parts of a market cycle. 2014 was an example of them identifying some major themes that unfolded over the year.
My comments in bold and italics. The rest is from Rich’s year-ahead piece, published a year ago.
1) The US stock market continues its bull run.
Rationale: We continue to believe that the US stock market may be in the midst of one of the biggest bull markets of our careers. It seems odd to us that investors seem to disregard the existence of a stock market cycle despite that the rotations and leadership in the US market have followed the normal historical pattern. Indicators that have historically been reliable forecasters of bear markets still seem quite benign. The yield curve remains positively sloped, valuation appears normal for this point in the cycle, and sentiment remains very attractive according to our models. Although stocks in 2014 might not provide returns as high as those during 2013, the US stock market’s return might be above average in 2014.
Comment: YTD performance of +14.5% in USD, is a continuation of the US bull run. Rich believes that we are in an elongated bull cycle. For many of us, he thinks, this will be the bull market of our careers. Read this: Lack of Corporate Hubris means an elongated cycle.
2) Japan outperforms emerging markets – The Currency Wars Begin.
Rationale: As of the date of this report, the Nikkei 225’s YTD total return of roughly 53% has far outpaced the MSCI Emerging Market’s -1%. We think Japan is likely to outperform emerging markets again during 2014. The aftershocks of the global credit bubble (i.e., massive global overcapacity and falling productivity in the emerging markets) could result in currency wars. Our bullishness on Japan in 2013 was based on a falling Yen, and we think Japan may be the first country to recognize that countries must compete on price (i.e., depreciating currency) in the absence of improving demographics and productivity. Although consensus return expectations for Japan do not seem conservative, we still believe that investors have yet to fully recognize the significant structural headwinds facing the emerging markets.
Comment: YTD Japan has returned +10.36% while MSCI EM is essentially flat. (Redwood Emerging Market Dividend is +6.5% YTD.) RBA’s theory is that Japan is creating competitive advantage through currency depreciation. They call it the ‘Wal Mart Strategy’ as Japan is now competing on price alone.
3) European small cap stocks lead global equity performance.
Rationale: The European economic recovery has lagged the US during this cycle, which is typical by historical standards. Smaller capitalization stocks tend to lead markets during most early-cycle periods. In addition, smaller capitalization European stocks currently have the world’s strongest 12-month earnings growth forecast, yet few investors seem aware of these superior growth prospects.
Comment: Uncertainty in Europe, particularly the lack of strong policy decisions by the ECB has contributed to continued uncertainty in Europe. The potential for this theme to develop will likely be based on the ECB policy and their approach to quantitative easing.
Keep this one on deck for 2015.
4) High yield municipals lead the bond market.
Rationale: We like to search for gaps between perception and reality, and there seems to be a wide gap regarding municipal bond fundamentals. Whereas investors seem quite wary of municipals, municipal finances are generally getting stronger. Investors also seem very concerned that interest rates will rise, but an increase in interest rates can actually improve pension funding status (the present value of future liabilities shrinks as interest rates rise). Because of such factors, high yield municipal bonds might lead bond market performance during 2014.
Comment: High yield munis – while not as attractive for Canadians, as they are taxable (ie. non-taxable for US residents) the price gain on the high yield municipal bond market was quite remarkable in 2014.
The HYMB in price terms has risen over 10% YTD.
5) Gold falls below $1,000.
Rationale: Investors often think of gold as a hedge against inflation, and history suggests that abnormally high inflation rates are often stimulated by strong credit growth. However, the global credit bubble is deflating, and developed economies’ inflation rates continue to fall without credit’s fuel. We can understand Yen-based investors’ interest in gold as the Japanese economy reflates (see #2), but we think US-dollar based investors should emphasize financial assets rather than real assets like gold. In USD terms, we think gold will continue its bear market, and could fall below $1,000/oz.
Comment: Directionally correct, gold has continued to fall with the strength in the US dollar. While we have not seen 1000/oz, RBA believes that continued USD strength and the potential for Fed balance sheet reduction, could continue to push gold lower.
6) The American Industrial Renaissance continues.
Rationale: Smaller, domestically-focused US industrial and manufacturing companies have been gaining market share, and we think that trend is likely to continue. Energy costs, productivity, transportation costs, quality control, political stability, and labor costs are some of the contributing factors. Despite the significant outperformance of these small and mid-cap companies in 2013, we feel the investment theme remains in its early stages and expect the theme to outperform again in 2014.
Comment: Continued job growth and solid GDP gains continue to support the thesis of an American Industrial Renaissance continuing to gain strength.
7) The Fed stays on hold much longer than investors expect.
Rationale: Contrary to popular belief, the Fed has historically been a lagging, not a leading, indicator. The Fed has said that policy changes will be “data dependent” during this cycle (what exactly were they in past cycles if not data dependent?), and we interpret that to mean that Fed policy changes may lag more than they did in previous cycles. The fear of replaying 2008 is not only still central in investors’ minds, it is apparently still central to the Fed’s decisions. If our assertions are correct, then stock market valuations could be higher and volatility could be lower than investors currently expect.
Comment: Still on hold!
8) Investors realize that the term “Liquid Alts” may be an oxymoron.
Rationale: During the early-1990s, I argued that illiquidity was one of the reasons alternative investments outperformed. Investors did not have ready access to their funds, and had to receive higher returns than available in liquid investments as compensation for taking illiquidity risk. Within that context, the term “liquid alternatives” seems like an oxymoron. Basic financial theory suggests that liquid alternatives should provide inferior return/risk potential versus illiquid alternatives. Ongoing fears of replaying 2008’s bear market suggest to us that investors may be paying too much for liquidity, and that liquid alternatives’ returns could be inferior to those of plain old-fashioned stocks.
Comment: Not sure that there’s a definitive answer here. Rich’s point is well taken, however liquid alternatives seem to be gaining interest and attention from investors and the market. We’ll call this one a push.
9) The king has no clothes: high quality stocks underperform.
Rationale: Many investors believe that quality stocks outperform over the long-term. Unfortunately, there is little objective data to support that contention. Rather, there is substantial evidence that “bad” companies have historically tended to make “good” investments over the long-term. Much like in #7 and #8 above, 2008’s lingering fears have led investors toward more conservative, higher quality stocks. We think that trend might reverse during 2014.
Comment: While you wouldn’t disappointed with the results of the S&P High Quality Index (SPHP:NYSE) the S&P High Quality Index (SPHQ:NYSE) has outperformed this year. Still three weeks left, and it’s a tight race, so stay tuned on this one.
10) Small banks.
Rationale: Bubbles create capacity that typically isn’t needed once the bubble deflates. The expansion of bank balance sheets was the capacity created during the credit bubble. Larger banks’ balance sheets ballooned during the credit bubble, but their balance sheets have yet to fully contract. Smaller bank balance sheets seem much better aligned to the post-bubble credit world. The S&P SmallCap 600® Bank index outperformed the S&P 500® Bank index by roughly 15 percentage points so far during 2013. We expect smaller banks to again outperform larger banks in 2014.
Comment: 2014 has seen the S&P 600 Small Cap Financial Index return 3.6%, relative to larger gains for the larger cap indices.
Investing in the Redwood Global Equity Strategy Class provides access to the key themes, identified by Richard Bernstein Advisors. RBA’s top down approach is unique in the Canadian market. In making their strategy decisions, RBA looks to make the correct beta and market cycle calls while removing the risk of individual companies hurting their results.
For more information on the fund – https://www.redwoodasset.com/investment-solutions/redwood-global-equity-strategy-class/