Hot List: Some Reasons for Optimism for 2015

In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John outlines a few reasons that could give investors continued optimism as we head into 2015 and beyond.

Reasons for Optimism

There’s no getting around it: 2014 was a rough year for the Hot List. While the S&P 500 returned 11.4% for the year, the Hot List lost 11.1%. A good portion of the underperformance was a result of smaller stocks struggling in 2014. My models, as you may know, tend to focus more on small- and mid-cap stocks than larger picks. Over the long haul that has helped us, but last year it weighed on performance.

Looking forward, however, I remain optimistic on stocks and optimistic that the Hot List will beat the market over the long haul. Of course, in the short term, no one knows what is going to happen; there are simply too many factors that move the market from day to day. But while I don’t know exactly what 2015 will hold for the portfolio, there are a number of reasons that I think now is a good time to be investing in stocks and in fundamental-focused strategies like ours. Here are a handful of those reasons.

Small-Cap Valuations
As a group, smaller stocks were pricier a year ago than they are today. At the start of 2014, small- and mid-caps were trading at a 26% premium to mega-caps. At the start of 2015, however, the premium was down to 23%. That’s good news for strategies that tend to key on smaller stocks, like ours. Since the end of 2005, when the small stock premium has been below 25% at the start of the year, small stocks have significantly outperformed. In such years, the Russell 2000 index of smaller stocks has beaten the S&P 500 each time, doing so by an average of nearly 5 percentage points.

Oil Prices
Oil prices are now down about 60% from their 2014 highs, and their rapid decline has created some worry among investors who fear that it is a sign of coming economic weakness across the globe. To be sure, growth has slowed in China and other big emerging markets, which has decreased demand. But it appears that other factors — the dollar’s ascent and a glut of supply — are more significant catalysts for oil’s drop.

With all that in mind, cheaper oil is a big benefit to businesses and consumers alike. When businesses have more cash, they can use it to pay dividends, buy back shares, or reinvest in their businesses, all of which benefit shareholders. And when consumers have more disposable income, it’s good for our economy, about two thirds of which is composed of consumer spending. There are possible downsides to cheaper oil, like job cutbacks in the energy industry and possible defaults on loans by overextended oil and gas companies, which could have some impact on the financial sector. But it appears that the positives outweigh the negatives right now.

The Strong Dollar
While the relationship between stocks and the dollar is a very complex one, a stronger dollar should benefit smaller firms, which tend to do more of their business at home in the US than larger companies, which often get a good deal of their profits from overseas in weaker currencies. Again, that’s a plus for our models.

US Strength

Over the past 6 to 12 months, the US economy has been as strong as we’ve seen it at any time in this recovery. In fact, by some measures, it has been as strong as it has been in well over a decade. Overall in 2014, for example, payrolls rose by an average of 246,000 — the best yearly average since 1999. The unemployment rate has fallen 1.1 percentage points since the end of 2013, with December’s 5.6% reading the best since June 2008. The broader “U-6” rate (which unlike the headline number takes into account those working part-time who want full-time work, and discouraged workers who have given up looking for a job) has fallen nearly 2 full percentage points since the end of 2013, and is now the lowest it has been since the financial crisis exploded in September 2008.

A big part of all this has been the US’s manufacturing boom. Through November, industrial production had increased by 5.2% over the past year (December figures aren’t yet available). If that held up through December, it would make for the highest annual gain since 2010, and the second highest since 1998. The manufacturing sector expanded in each month of 2014, according to the Institute for Supply Management, with output really picking up in the summer and fall. The service sector also expanded in each month of the year, in most months by a significant amount. That makes it 59 straight months that the sector has expanded, according to ISM. All of this helped the US post gross domestic product growth of 5.0% in the third quarter — its strongest quarterly growth rate since 2003.

The improvements in the US have come at a time when Europe and emerging markets are struggling. While the economy and stock market are not always attached at the hip, the US’s relative strength versus the rest of the world should continue to keep money flowing into US stocks, especially given that …

Valuations & Sentiment Conditions Are Still Attractive

Over the past year or two, many pundits have continue to say that stocks have gotten significantly overvalued, and that sentiment has gotten far too bullish. The data just does not back them up.

A survey done by Yale that asks investors how confident they are about the stock market over the next year, for example, shows that individual investors confidence levels have recently been at or near 25-year lows. Institutional investors’ confidence levels have been at their lowest level since about 2000.

In addition, consider what Charles Schwab Chief Investment Strategist Liz Ann Sonders recently had to say about valuations. “S&P earnings have tripled since March of 2009, while the stock market is up [about] 245%,” she wrote. “From the negative low in earnings, the E in the market’s P/E has appreciated well more than the P, which is why valuation is no worse than about neutral now. In fact, both on a trailing and forward basis, the market is about at historic median P/Es; while most of the macro conditions supporting higher valuations remain in place.” As for claims that valuations have risen artificially thanks to quantitative easing and ultralow interest rates, Sonders adds, “Interestingly though, the multiple expansion in this bull market has been about average for bull markets since 1957. So if valuation expansion has been average, why have stock market returns been so high? Earnings! Earnings growth in the current bull market has been 20% above the average level of growth for all bull markets since 1957.”

When valuations are reasonable and sentiment is relatively sour, you often get a good environment for stocks — one in which the market can avoid getting overheated and can keep climbing a wall of worry.

Staying Disciplined

In the end, no one knows exactly what 2015 has in store for investors. But as I noted above, a number of factors bode well for our models going forward. More importantly, these strategies have proven to be winners over the long haul, and they’ve done so by picking attractively priced shares of solid companies. While doing so doesn’t always work (nothing always works), that approach has been a winning one for long-term investors since the stock market was created. The worst thing an investor can do is ditch a solid strategy because of short-term struggles — it’s the equivalent of buying high and selling low. So we’ll stay disciplined and stick to the gurus’ strategies, and over three long haul I’m confident that will lead to significant outperformance.