The last six months have not run according to anyone’s plan. Who would have thought that equity market structure would yield a best-selling book, after all? As ConvergEx's Nick Colas notes, on the fundamental side of things, interest rates across the developed world are lower, not higher – counter to the consensus view just 180 days ago. Mutual fund investors first bought U.S. equities earlier in the year, then in the last 6 weeks have begun to liquidate in earnest. Exchange Traded Fund investors are buying more fixed income products than those dedicated to U.S. stocks. Large cap stocks are trouncing small caps in terms of performance. And as for volatility – well, Elvis has clearly left the building on that one. So which of these surprises has staying power into the back half of 2014?
Expect the market structure debate to continue, and look for higher interest rates and more of the same slow churn higher for stocks. And that long awaited 10% correction? Probably not until 2015 – which is only 189 days away…
Via ConvergEx's Nick Colas,
What a year the first half of 2014 has been – one to humble the savviest prognosticator, really. As the ball dropped in Times Square 176 days ago, the narrative for capital markets was blissfully simple:
Economic growth would accelerate in the US, stocks would do well, bonds would retreat, and investors would grow bolder in their equity allocations.
Small cap stocks would outperform large caps, if only because they had the wind at their sails as we exited 2013.
Equity markets had a good chance to see a 10% correction, probably early in the year.
We got exactly none of those outcomes, proving the old adage that “If you are going to predict the future, do it often.” With that in mind, today we offer up a list of ‘Top Five Surprises of 2014’ and some comments about which of them has the staying power to make it to 2015.
Surprise #1: Market Structure Can Be Interesting. The biggest surprise of the year is actually not from the world of economics or asset prices. It is that, with a clever enough narrative, people outside the financial profession will care about the world of maker-taker pricing, high frequency trading, and how the plumbing of the U.S. equity markets actually works. Michael Lewis’ “Flash Boys: A Wall Street Revolt” may no longer be on the Amazon best sellers list, but it’s still inside the top 150 and has over 1,500 customer reviews and a 4.5 star rating. Predictably, you can buy it as a bundle with Thomas Piketty’s “Capital in the Twenty-First Century” if you click the “We’re All Doomed” package offer.
Easy prediction here: this issue isn’t going away. SEC Chairwoman Mary Jo White’s recent speech on market structure points to a lasting interest in the topic on the part of the Commission. No doubt the eventual alterations won’t be enough for some market watchers, but the Street is abuzz with chatter of the changes many traders expect to come in the next 6 months.
Surprise #2: Interest Rates Are Never, Ever Going Up Again – Or So It Feels, Anyway. This was supposed to be the year where the U.S. Treasury curve steepened to reflect accelerating economic growth and the chance for greater inflation. It was the “No Brainer” trade of the first half. Turns out that the zombie-like move lower for rates explains the lack of brains. Momentum, disappointing economic growth during a tough winter, a still sluggish labor market with few signs of wage inflation, a Europe on the brink of deflation - the list of reasons for a bond market rally this year are long and distinguished.
So where do we go from here? It is hard to imagine a world where both 10-Year Treasury yields at 2.56% and the S&P 500 at 1960 are sustainable levels. Either bonds are right and U.S. economic growth will remain moribund, or equity prices correctly reflect a better second half. Yes, bond investors tend to get these calls right more often than their equity brothers and sisters, but we are going to side with stocks here. Bond yields should back up in the second half, to the 3% on 10-year levels we had at the beginning of 2013. The reasons – slightly better economic growth (2.0-2.5% GDP for 2H 2014) and the end of the Federal Reserve’s bond buying program. A little more inflation – visible, CPI headline and core inflation – would be helpful too.
Surprise #3 – Retail Investors Are Back! Well, they were for a while. According to the Investment Company Institute, mutual fund investors in the U.S. finally started to buy domestic equity funds from January to April 2014, to the tune of $18 billion. The bad news? Since the first week of May, they have redeemed $15 billion. The trend is not U.S. stock’s friend here. Looking at Exchange Traded Fund money flows, courtesy of our friends at www.xtf.com, and the data is modestly more positive. Total ETF money flows into U.S. listed products totals $69 billion year to date. Of that, $19 billion went to U.S. equity products. Not bad, until you consider that ETF investors added $22 billion to fixed income funds over the same period.
Calling money flows over the back half of 2014 into ETF products is pretty simple – it will likely run about $150 billion, or just over double the first half run rate. December is usually a big month for ETFs with tax loss selling, so that’s the reason for the slightly better whole-year numbers.
As for retail investors into mutual funds, that’s a tougher call. Keep in mind that from the March 2009 lows, mutual fund investors have redeemed just over $350 billion of assets from U.S. stocks funds. Yes, into the teeth of a massive bull market, mutual fund holders have sold their positions all the way up. Seasonally, the balance of the year is not generally good for mutual fund money flows, as higher income earners usually hit their contribution limits with the Q1 bonus payments.
So who is left to buy? We can think of three constituents. First are public companies themselves through their buyback programs. Second are hedge funds chasing performance. Lastly are individual investors buying single names. We tend to believe that ETFs have replaced a lot of single-stock asset allocation decisions for this group, even if active traders still focus on individual names.
Surprise #4 - Small Caps RULE!... Until they don’t. The Russell 2000, one of the most widely followed small cap indices out there, has been a major disappointment this year to date – up only 2.0%. By contrast, the S&P 500 is up 6.0% and the CRSP Total Market Index (a market cap weighted index of the 1475 largest names by that measure) is up 5.8%. Now, taken over the last year, the performance numbers are very close – Russell up 23.1%, S&P 500 up 23.4%, and Total Market up 24.2%.
So will small caps start to outperform large caps now that their performance has reset to the market averages? I tend to doubt it, for two reasons. First, with the European Central Bank’s aggressive monetary policies – current and future – will create hope for a better 2015 on the continent. Larger companies tend to have more overseas operations than smaller ones, so they stand to benefit from those moves. Second, the economic picture in the U.S. is likely going to remain tenuous for much of the third quarter and perhaps into the fourth. That pesky 2.56% yield on the 10-Year Treasury tells you all you need to know there. Larger companies tend to be more defensive than higher-beta small caps, and investors looking for equity exposure will likely dust off the late-cycle playbook and move upstream just in case the hoped-for acceleration does not come to fruition.
Surprise #5: Elvis – and Volatility – Has Left the Building. Aside from the surprising fact that Michael Lewis could get people interested in how stocks trade, the biggest surprise in 2014 thus far is that no one seems to care how stocks trade. If they did, there would be more investors expressing divergent viewpoints and pushing volatility higher. Instead, actual volatility remains low and options prices indicate that few people think that will change materially any time soon. The long run average of the CBOE VIX Index is 20; it currently sits at 11.6, or more than one standard deviation from the mean.
What will drive volatility back into the markets? Yes, a large geopolitical shock is always good for jolting investors back to reality. So that could happen. But aside from that, it seems we are in for a long slow summer and early fall for 2014. I was writing about the VIX back in 2007, the last time it got here. And if you want to say “Aha! – that reversion in volatility averages will happen again!”, let me remind you that the VIX was also here in 2005. And 2006. Volatility, or the lack of, can linger far longer than you think possible. And one last word on the topic – the VIX tends to bottom for the year in December. Not the summer.
In the end, it seems that the first half of 2014 is largely a prologue for the second half. Would it be nice to get more volatility (better opportunities to find mispriced securities) and see rates back up (pushing money into stocks)? Yes on both counts. And we should get some movement on rates. But as for stocks, volatility seems to be more of a 2015 game. But don’t feel bad – that is only 189 days away.