5 Themes for 2015

January 8, 2015

A look back at 2014 may shed some light on what could be ahead for 2015 with multi-asset class trading dynamics suggesting that a slow-motion repricing of risk and/or flight to liquidity may be underway.

Possible themes that may play out in 2015 as a reflection of investors possibly moving toward conservative assets and away from risk assets include the following.

  1. Increasing Multi-Asset Class Volatility
  2. U.S. Dollar Strength
  3. Commodities Continue to Sell Off
  4. Bonds Stay In Rally Mode as 10-Year Yield Goes Lower, and,
  5. (5) Equities May Prove Tricky.

2014 turned out to be an interesting year for the financial markets with the S&P 500 finishing up 11.4%, the CRB Index closing down 17.9% as the U.S. dollar moved sharply higher on falling interest rates based on end-of-year data from Thomson Reuters.

We believe many investors were surprised by how the year shaped up nor does this seemingly odd scenario fit many standard models of how financial markets should perform. “Odd” because stocks and bonds are not necessarily expected to perform well at the same time and the dollar should strengthen on rising rates.

It seems important, then, to ask at least two questions. First, what exactly is going on here?, and second, what does it mean for the markets in 2015?

An exact explanation is unlikely to be produced considering that financial market analysis is as much of an art as a science as central bank policy is but we tend to think 2014’s market dynamics may reflect a slow-motion repricing of risk and one that is likely to intensify in 2015.

What exactly does this mean? Most simply, it appears that smart money started moving out of risk assets in 2014 and into more conservative assets.

Allow us the exercise of offering an overly simplified diagram of a multi-asset class risk spectrum ecosystem that only includes asset classes that are of interest to us for the purpose of answering the questions above.

Starting with the first part of the repricing of risk proposition or the idea that some investors have been moving out of risk assets, this is supported by the fact that EM equities and high-yield bonds were down as much as 18.9% and 10.9%, respectively, from peak to trough during 2014 according to data from Thomson Reuters on iShares MSCI Emerging Markets (EEM) and SPDR Barclays High Yield Bond (JNK).

Something more subtle may be happening here as well, though, and this is something that we like to refer to as a flight to liquidity. This means that investors sell less liquid assets such as commodities and high-yield bonds for the relative safety of more liquid assets and the early stages of this dynamic appear to have shaped 2014.

What are we to make of U.S. stocks however? Many of the indices finished the year at new all-time record highs with the DJIA having taken on the big round number of 18000.

Clearly this strong finish may not fit a repricing of risk but there are at least two things to make note of here.

One is the idea that some of the money to come out of illiquid commodities and high-yield bonds may have gone into the relative liquidity of equities – for now. We say “for now” due to the second factor to make note of and this was the increasing volatility that hit stocks last year. Using one of the most volatile of the U.S. indices as an example, the Russell 2000 finished 2015 near its record highs but between January 2, 2014 and December 31, 2014, this small cap index traded in at least 6 distinct whipsaws based on data from Thomson Reuters. Down 8%, up 12%, down 9%, up 12% down 14%, up 17% and something similar but of a smaller scale shaped the other indices in a more subtle way.

We tend to think, then, that 2014’s strong finish in stocks is slightly deceptive as far as what was really going on in the equity markets and this is particularly true considering that the tremendous sell-offs of February 3, July 31 and October 15 appear to have built on each other relative to intensity and we think there is more to come. In fact, the pattern of whipsaws outlined in the Russell 2000 above all but suggests that another bearish whipsaw may be coming and one that could be larger than the last one.

Now turning to the second part of our repricing of risk contention is the idea that investors are moving toward more conservative assets such as U.S. Treasurys and the U.S. dollar index, which both rallied significantly in 2014.

The 10-year yield moved as low as 2.07% from 3.01% in 2014 according to data from the U.S. Department of Treasury on a strong rally in bonds with yield moving inverse to price. Considering that this rally came in the face of a Fed that successfully exited from its third bond buying program that supported the bond market, we tend to think that investors bought Treasurys as a place to “tread water” at the very least or prepare for a real flight to safety ahead with the goal of benefitting from what could be appreciation from a total return perspective or otherwise.

Such a possibility fits our repricing of risk contention, perhaps even helps to create it, and we are unable to come up with another possible explanation around this bullish movement in bonds at this time.

Turning now to 2014’s tremendous rally in the U.S. dollar index, however, it does not necessarily fit this thesis considering that the dollar’s strength may have – hopefully did – come on the improving prospects for the U.S economy. This is an optimistic interpretation considering the lumpy, mixed data that came out in 2014 but one that we like very much should the data become consistently strong in 2015.

But another possible explanation for the recent dollar strength does support a repricing of risk in the idea that investors are getting out of some of the risk assets, especially the illiquid ones, and moving into safe liquidity and perhaps in preparation for the possibility of a more obvious repricing of risk that could come in the form of a bull market-ending correction in 2015.

Which explanation is better or, more importantly, accurate? Only time will tell, but we think these tensions on the risk spectrum bring to light 5 themes that may play out in the financial markets in 2015 and are very likely to shape the way we manage our client portfolios.

1. Volatility May Prove to be the Name of the Game in 2015. This is saying something considering the “unstable, unpredictable and explosive” moves across all asset classes in 2014, but we tend to think that was only the beginning. It has been said, volatility breeds volatility and we think this will be proven many times over in 2015. There may be big moves in the currency markets, and especially around any yen pairs and any euro pairs, that will likely ripple into other asset classes in the form of significant rallies in conservative assets and perhaps severe sell-offs in risk assets. Relative to one of the more common ways of thinking about volatility through the VIX, we believe this index may spike significantly higher as stocks perhaps sell off.

Bottom-line: Investors may need to be prepared for wild market moves in 2015. As such, investors, may want to consider carrying portfolios that can be reallocated quickly along with having a plan in place to do so practically ahead of any possible turbulence.

2. U.S. Dollar Index May Remain Strong But Could Get Caught Up in some Sideways Volatility. Medium/long-term, we expect the U.S. dollar index (U.S. dollar measured against a basket of other major currencies) to rally significantly in the years ahead as has been our expectation for more than four years now and 2015 is unlikely to be an exception. However, considering that the U.S. dollar index hit its highest level since April 2006 according to Thomson Reuters data, there is a good chance some of those gains are briefly consolidated before it moves higher. This is not to say that this sort of volatile consolidation must happen, but just that it is a strong possibility. Should the U.S. dollar index ultimately perform well in 2015, however, it will be very interesting to see whether it was on a strengthening U.S. economy or on some sort of flight to safety.

Bottom-line: Time will tell what is behind the dollar strength, but investors may be wise to consider cash as a position of value in times of market volatility.

3. Commodities May Continue to Sell Off. This means that the deep bear market in commodities is likely to continue for another year to levels that may match our medium/long-term views on the CRB Index held for more than four years. Interestingly, there is some possibility that this potential and continued slide may prove to be somewhat orderly, but based on crude oil’s sharp sell-off in the end of 2014, it probably makes sense not to bank on it. This is particularly true considering that crude oil may sell off by at least another 15-35% with the precious metals looking vulnerable to similar declines.

Bottom-line: Considering the potential illiquidity in the underlying commodity markets, investors may want to avoid calling “bottoms” in commodity-related ETFs and holding relatively small and easy-to-manage positions in those securities in 2015.

4. Bonds Are Likely to Stay in Rally Mode. At some point, rates will rise, but we tend to think the 10-year yield is going lower before it moves higher. Specifically, we believe the 10-year yield is likely to spend more time below 2.00% than above it in 2015 and perhaps significantly so. This possibility supports our repricing of risk contention as investors perhaps seek safety in a time of market volatility.

Bottom-line: Bonds may continue to perform well in 2015 and investors may want to consider owning Treasury-related ETFs even though the chart technicals are a bit skewed in some.

5. Stocks May Prove Tricky For Investors. Greenbush Financial Group has been on the right side of the bull market for its clients over the last nearly six years, but we are concerned about a few factors. These “red flags” include: (1) the increasing volatility in the equity markets in 2014 and particularly in small cap stocks, (2) broken medium/long-term uptrends in the broad U.S. equity indices, and, (3) weakness in emerging market equities.

As was stated above, we tend to think that 2014’s market volatility was likely a “warm-up” for more of the same to come and especially considering that these gyrations breached the DJIA’s bull market uptrend and something that typically signals a severe reaction to the downside. This possibility is showing in MSCI EM considering that this emerging market index nearly moved into bear market territory twice in 2014. Importantly, it tends to lead U.S. equities due to the fact that EM equities are further out on the risk spectrum.

Bottom-line: Stocks are likely to be volatile in 2015 and investors may want to be prepared for “anything” by having a plan in place on how to deal with this potential volatility.

In summary, then, 2015 may become best known and remembered for massive, multi-asset class volatility and something that aggressive traders love but many investors dislike. Behind it?

It’s impossible to know for certain and the causes are multi-sourced for certain, but if we were to choose one word to describe why the markets could be hit by big volatility in 2015, it is Europe.

And this, friends, is a topic for another week and one that we look forward to discussing soon.


Courtesy of http://www.peaktheories.com

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