The S&P/TSX Composite Index slipped another 0.7% in December, adding to its 4th quarter loss of 2.2%.  The index did, however, show a net gain for the year, rising 7.4% for all of 2014, after rising 9.6% the prior year.  Despite losing 0.4% in December, the S&P500 Index was up 11.4% in 2014.  European markets were mostly down in December and finished the year with net losses, with Greece once again the worst, losing 37.4%.  China was the big winner in 2014, gaining another 19.5% in December alone.  Investors shifted funds into stocks on expectations of easier central bank policies, pushing the Shanghai Index up 49.3% for the full year.

While the U.S. economy continued to chug along at an impressive rate, registering a 5% growth rate in the 3rd quarter, the data across the rest of the globe continued to be weak.  Chinese growth has slipped back to the 7% level, the lowest since the financial crisis, while European growth is stagnant at best.  Falling oil prices and international sanctions have taken their toll on the Russian economy, which is now expected to shrink by 4-5% next year while the Ruble depreciated another 20%.  Other emerging economies are also dealing with capital outflows due to the strength of the U.S. dollar and are raising interest rates in order to retain those funds.  Canada did relatively well due to our proximity to the U.S. and strong auto sales, but falling oil prices will restrain growth more in 2015 as over 50% of Canadian capital spending is associated with the energy sector.

Our stock market strategy for 2015 can be summed up in one word; cautious!  Stocks have seen tremendous gains over the past five years and we remain bearish on the short-term outlook.  Although we don’t see a recession in the next year, economic growth is clearly slowing and missing expectations in most regions including recent data out of Japan, China and Europe.  The U.S. economy will also face more headwinds over the next few quarters from a higher US dollar, slower overseas growth and slightly higher interest rates.  Stocks, meanwhile, have been supported by higher earnings multiples (over 75% of gains over past 2 years on global markets due to higher valuations rather than earnings growth) and corporate stock buybacks (often funded through bond financings at low interest rates) while earnings per share are boosted by those same buybacks.  Meanwhile, investor concern about stocks, as measured by volatility, is at record lows.  This is all highly reminiscent to us of 2007, except that the real estate bubble this time around is in China, not the U.S.  Resource stocks have been under severe pressure as slowing global growth pushes commodities down while non-resource stock valuations are at record highs for those sectors.  We remain at maximum cash/minimum stock levels in all of our managed accounts.  Moreover, we have a net short position in stocks in our ‘global macro’ Hedge Fund.  We see little, if any, short-term upside for stocks in this scenario and a much higher risk of a substantial correction.  Fixed income investments and preferred shares remain our best alternatives for now.

U.S. stocks continued to play the ultimate game of survivor in December as the market fell over 5% mid-month on plummeting oil prices and carnage in the high yield bond market, only to respond to ‘soothing words’ from U.S. Federal Reserve Chief Janet Yellen and then rallying to new highs before Santa even had a chance to get his sled out!  Monetary policy-makers such as the U.S. Fed, the ECB, the Bank of Japan (BOJ) and the PBOC (China) continue to be the dominant players in driving stock prices higher.  While the skeptics (including us at this point) continue to question the wisdom of extricating yourself from a debt crisis by issuing more debt, the reality seems to be that these promises of endless low levels of interest rates are emboldening investors to believe that these central bankers have their ‘backs covered’ against a market meltdown of any sort.  Higher valuations for stocks have driven over 80% of the world’s stocks market gains over the past 2 ½ years, meaning that less than 20% can be attributed to higher earnings.  And while the market’s focus is typically on stocks, all financial assets have been dragged higher in this process, including government and corporate bonds, private equity and merger activity.  Chinese stocks were another recent case of ‘bad news is good news for stocks’ as weaker economic data lead to more aggressive buying of stocks, with the Shanghai index gaining another 19.5% in December alone.  Investors shifted funds into stocks on expectations of easier central bank policies, pushing the Chinese market up 49.3% for the full year.

We once again started to see some cracks in the armour of the U.S. stock market last month, though, as collapsing oil prices sent stock prices tumbling early in the month.  As the world’s largest energy producer now, the net impact of a collapse in oil prices is not quite as clear cut as it used to be.  While falling gasoline prices are like a giant tax cut for the entire economy, the big regions of shale oil development such as Montana, the Dakotas, Texas and Oklahoma have been the sources of the greatest job growth and infrastructure spending during the recovery, and that trend clearly won’t continue.

Moreover, the weakness in oil prices also presents risks for the high yield debt sector.  Energy sector debt now represents over 16% of the $1.3 trillion U.S. junk bond universe, surging fourfold in just the past decade.  We’ve reached a point now where nearly one-third of this energy debt is priced at distressed levels; total returns in that area were flat for the year versus +4.2% for the overall high-yield corporate bond space and average bond yields jumped to 7.3% from 5.7% at the turn of the year.  This last drop in oil prices below US$55 a barrel is widely seen as sparking a wave of defaults that bears some comparison to the heavily indebted telecom industry heading into 2000-2001.  The energy industry has issued US$1.2 trillion of new bonds since 2009 and this accounted for 7% of all corporate bonds placed over that period – this is nearly double the US$622 billion the industry borrowed from 1995 through 2008!

The breakdown in the high-yield (junk) bond market should serve as a warning for stock investors.  The chart below shows the correlation between high yield bond prices and stock prices over the past seven years.  They clearly moved in line through the financial crisis and most periods since that time but have diverged over the past year as stocks have continued to rally while high yield bonds have checked back.  I’m more comfortable with the bond investors’ cautious outlook implied by these results rather than then stock market investors’ bullish reading.

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