I remain convinced that U.S. stocks are the place to be and that Wall Street is enjoying a secular, or long-term, bull market, based on a variety of positive influences:
- Historically low interest rates
- Inexpensive energy
- A manufacturing renaissance
- Technological innovation
- Accelerating growth
- Decelerating deficits
- A confident consumer
- Washington working again
- More robust demand for residential real estate
I have been operating on this thesis for close to three years now and, with the exception of a meaningful rebound in real estate, more has gone right in each instance than wrong.
However, there are risks in 2015, starting with the one that worries me, in some ways, the most.
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Over the last several years, no one believed that the factors that helped revive growth, and lift stocks to record levels were, real.
It was all ephemeral, a Federal Reserve-induced sugar high from which investors would ultimately come down hard.
I was disappointed to see headlines of late suggesting that Wall Street strategists are almost uniformly optimistic that 2015 will be an up year for stocks.
From a contrarian perspective, a significant correction early in the year would be most unexpected, and unwelcome, to those who just joined the party. But that's the contrarian in me suggesting that when everyone jumps into the pool, it's time to get out. (I don't believe that is entirely the case just yet. This could simply be a case of the frights in an overbought market).
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However, there are also real risks that are making themselves known as we enter the new year.
The "Grexit" has re-entered Wall Street's lexicon, as fears of Greece leaving the euro zone, defaulting on its debt, and sinking deeper into political and economic chaos, have re-emerged as an issue in Europe.
Deflation is also becoming an increasingly intractable problem in Europe, as German inflation, today, fell again, accentuating the deflationary pulse that is ripping through the Continent and demanding action be taken by monetary policy makers. That action, while expected later this month, may be too little, too late.
How much lower can Continental interest rates fall with the advent of quantitative easing in Europe? German bunds yield 0.5 percent, while interest rates are plummeting in Spain, Italy, Portugal, France, and even in the UK. The next step for 10-year paper in Europe is zero. That would certainly shock the European economy, for good, or ill -- I'm not entirely certain.
The rapid collapse of crude oil prices, while a boon to consumers, has become a double-edged scimitar, thanks to the speed with which prices have fallen.
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In addition to pushing oil-producing nations to the brink of bankruptcy (which from a geopolitical perspective may be a desirable outcome in Russia, Iran and Venezuela), it could also lead to defaults on high-yielding debt used to finance speculative energy projects in the U.S. It is estimated that about 28 percent of all high-yield debt of recent vintage, was raised to finance such endeavors. With oil well below the break-even level for high-cost extraction, a wave of defaults could be imminent, and could create a 1998-style disruption in financial markets, as when Russia defaulted on its debt, devalued its currency, and led to the implosion of a major hedge fund, Long-Term Capital Management.
With the rapid collapse in oil prices, geopolitical risk may be rising as well. Russia is falling into recession, starved of energy revenues used to finance its national budget, as are many other oil-dependent nations.
Its currency, the ruble, is still under siege, and Russia's unpredictable president could use domestic unrest as a pretext to distract the disenfranchised at home by making trouble abroad.
The dollar's rapid ascent is exacerbating the problem by putting further downward pressure on commodities, inviting foreign capital into the safety of U.S. assets, and importing deflation to the U.S., a development which, to an extent, is being telegraphed by global bond markets. Yields are falling almost everywhere, suggesting that deflation remains a clear and present danger to the global economy and, to a lesser extent, the domestic economy as well.
The dollar's strength threatens, also, to weaken U.S. exports, (by making them more expensive overseas), cut into multi-national profits, and act as a de facto tightening of monetary policy.
Having risen 14 percent since spring, the old rule of thumb suggests that every 10-percent increase in the value of the dollar is equal to a half-point interest rate hike by the Fed.
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That means monetary policy has been "snugged" by three-quarters of a percent, at this juncture, in the dollar's recent rally.
And so, just as everyone became complacent about market risk, risk is rearing its ugly head once again.
I believe the U.S. will weather the storm, and suffer, at worst, a correction. But that belief is also predicated on the Federal Reserve NOT raising rates in 2015, by Washington developing a policy response to OPEC's assault on U.S. fracking fields, (lifting the ban on crude oil exports would be a great start), and by the U.S. consumer using a lower cost of living to spend more in the months ahead.
The market, it is said, climbs a wall of worry. Well, Wall Street is getting off to a worrying start. Hedging may be a good strategy in the days and weeks ahead.
For now, given the rapid pace of action, this feels more like a correction than the beginning of a bear market.
But as John Maynard Keynes said, "When the facts change, I change my mind."
That thesis may be aggressively tested early in the year, but I'm still betting that the first set of facts will overshadow a new set of factors that presented themselves in just the last few days.
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