Fourth Quarter 2014 Market Commentary
Doug Ramsey, CFA, CMT
Chief Investment Officer
Last year marked the sixth consecutive annual gain for the S&P 500, a feat not accomplished
since the 1990s. The character and leadership of last year’s stock market certainly fit the pattern of an
aging cyclical bull market, with Large Cap stocks in economically defensive sectors emerging as the big
winners (Consumer Staples, Health Care, and Utilities). Small Caps—which entered 2014 at a record
valuation premium in relation to Large Caps—trailed the S&P 500 by almost 10 percentage points for
the year, while foreign stocks also lagged, thanks in part to a second-half surge in the U.S. dollar.
After having been bullish for most of the past six years, our Major Trend Index (MTI) and other
market tools now point to an environment of elevated risks. The MTI has spent the last three months
in “neutral” territory, prompting us to hold our tactical accounts’ net equity exposure at a below-average allocation of 50%. We suspect the next move in the MTI will be a decline into negative territory,
which would trigger an additional reduction in net equity exposure, likely to the 30-35% range. But
the bull market has surprised us before: over the past couple years, every time it’s looked a bit ragged,
it’s found a way to rejuvenate itself. Reaching a bull market top can be an extended process, and we’ll
need more decisive bearish evidence from our quantiative work before further reducing net equity
exposure in tactical accounts.
Our Intrinsic Value work suggests that U.S. equities remain moderately overvalued, with valuations on the “median” or “typical” stock more inflated than those for the capitalization-weighted
market averages. For example, the median Normalized P/E ratio on the 3000 stocks in the Leuthold
domestic stock universe is 24.9x, well above that of the cap-weighted S&P 500 (20.9x P/E ratio). Typically, the median stock trades at a small P/E discount to the S&P 500. Mid and Small Cap U.S. stocks
could therefore prove especially vulnerable during the next major market decline.
On the positive side, valuation risks for foreign stocks look considerably lower after another
year of underperformance. The MSCI World Ex-USA Index trades about four P/E points below the
U.S. (at 16.8x Normalized EPS), and Emerging Markets are even cheaper (12.1x EPS).
Our quantitative equity strategies had strong results in 2014, with our equity industry group
work locking in some of the year’s best-performing themes (including Airlines, Managed Health Care,
and several industry group winners within the Technology sector). Our analyses of valuations and capital spending trends support the potential for a multi-year phase of stock market leadership from the
Technology sector. Among our current equity industry positions are Semiconductors and the Technology Hardware & Storage group.
(Continued)
Leuthold Weeden
1
Capital Management
Fourth Quarter 2014 Market Commentary
(continued)
Our equity industry analysis in 2014 was also notable for helping us to avoid certain areas, specifically, the Energy and Materials sectors, where the inflated capital spending levels (we’ve warned of in recent years) finally culminated in a broad-based commodity price collapse in 2014’s second half. We believe
global production capacity for most commodities remains too high, but admit that valuations in some of
these groups (particularly within the Energy sector) now look appealing. We’ll be watching our industry
models closely for a buying opportunity, perhaps later this year or early 2016.
Fixed income exposure in our tactical funds remains low, at 20%, reflecting a lack of value (and
yield, for that matter) across most sectors of the global bond market. But the lack of value and lack of yield
is nothing new. We felt much the same way a year ago when the yield on the 10-year U.S. Treasury bond
hit 3%, yet to our surprise, fixed income played a valuable supporting role in our tactical portfolios during
2014 as long-term Treasury yields fell sharply. Following last year’s strong bond rally, we’ve cut the average
maturities of our fixed income holdings to about 4.5 years, and continue to focus on high quality credit.
As we begin the new year, our portfolios are positioned in areas that we believe are apt to best withstand the challenges of a late stage bull market, and we're confident that our disciplines will direct us to
make adjustments, when needed, as the year progresses.
Please feel free to contact us if you have any questions. Thank you for your support.
Sincerely,
Doug Ramsey, CFA, CMT
Chief Investment Officer
Leuthold Weeden
2
Capital Management
ageme
Other Market Notes
Sentiment: Frothier Than You Think
Last year will certainly go down
as the bull market year in which investors were finally retrained to buy the
dips (as they usually are, late in every
bull market). Most of our Attitudinal
measures—ranging from option activity and bear fund assets, to surveys of
investor sentiment—show retail investors finally shaking off the worry that
gripped them for most of the bull market’s first five years.
Certain sentiment readings have been notable not just for their levels, but their persistence. This is evidenced by Investor’s Intelligence weekly survey of market newsletter writers, where the 2014 annual “average”
level of bullish sentiment was the second-highest in the survey’s 51-year history.
It’s well known that sentiment extremes (especially optimistic ones) can
persist for long periods before an eventual mean-reversion kicks in. However, we
found that average annual readings from this survey possess (as theory would suggest) a healthy negative correlation (-0.35) with the subsequent year’s action in the
S&P 500. The correlation grows even more powerful at major sentiment extremes
(such as the current one). Table 1 shows the ten highest “average sentiment” years
since 1964; of the nine years prior to 2014, three of the years were followed by an
annual gain of just 3% or less (about flat)—and three of the years were followed
by years experiencing double digit losses. The overall average gain of all years’
results was just +0.1%; none of these high sentiment years was followed by a truly
great year for stocks.
At the other end of the spectrum are the ten years with the lowest annual
average sentiment readings. A quick scan of Table 2 shows that many of these
low confidence years are, as expected, associated with bear markets. However, the
lowest average sentiment reading occurred in 1994, a flat year for the blue-chip
averages (which of course provided the springboard for the 1995 market blast-off).
The return profile for years following these low sentiment reading years is excellent, with only a single loss (1968), and an average S&P 500 gain of +17.4%.
The Investor’s Intelligence survey used in this study is reviewed within our
Major Trend Index, along with about 30 other Attitudinal inputs on a weekly basis. But, we wonder if we should attach more weight to the persistence of a given
sentiment condition, considering that behaviors which ultimately undermine an
economic recovery and bull market (economic malinvestment, heavy issuance of
high yield debt/leveraged loans, etc.) require a sustained period of confidence to
foment. Optimists might claim we’ve just entered such a phase; our work suggests
this phase is well-advanced.
Leuthold Weeden
3
Capital Management
Table 1
Table 2
Other Market Notes
Years Ending In “Five”-- An Anomaly We Can't Explain
We’ve written periodically about the Presidential Election Cycle in relation to stock prices, sheepishly acknowledging both the persistence of the pre-election year effect and its pervasiveness across many markets. Since
1898, the DJIA has produced an average gain of 12.3% in years preceding a presidential election year, versus an
average 7.6% gain for all years. Results are even better if years prior to WWII are ignored.
A possible explanation for the pre-election phenomenon would be a ramp-up in stimulus supporting reelection efforts. But there’s no rationale for the anomaly we’ve heard mentioned frequently in recent weeks: the
bullish “Year Ending In Five” effect. Yes, such years have tended to be great ones in the stock market, with an average DJIA gain of 34.6% (though the pattern failed in 2005, with a DJIA loss of 0.6%).
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Leuthold Weeden
4
Capital Management