PALM BEACH (TheStreet) -- "Never make predictions, especially about the future." -- Casey Stengel
It's that time of the year again!
By means of background, 12 years ago, I set out and prepared a list of possible surprises for the coming year, taking a page out of the estimable Byron Wien's playbook, who originally delivered his list while chief investment strategist at Morgan Stanley then Pequot Capital Management and now at Blackstone. (Byron Wien's list will be out in early January and it will be fun to compare our surprises.) I often speak to and get input from some of the wise men and women that I know in the investment and media businesses.
I set out as a primary objective for my Surprise List (see 2014) to deliver a critical and variant view relative to consensus -- that can provide alpha or excess returns. Economic and stock market histories have proven that (more often than generally thought) consensus expectations of critical economic and market variables may be off base.
Below I outline the lessons I've learned over the years, how my predictions have historically done, what the consensus is for 2015 and my rationale for my 15 surprises. It's useful background in understanding the markets in 2015. That said, to jump to the first 2015 surprise (and how to take advantage of it), click here.
Must Read: Doug Kass on the Market: A Life on TheStreet
Lessons Learned Over the Years
"I'm astounded by people who want to 'know' the universe when it's hard enough to find your way around Chinatown." -- Woody Allen
There are five core lessons I have learned over the course of my investing career that form the foundation of my annual surprise lists:
1. how wrong conventional wisdom can consistently be;
2. that uncertainty will persist;
3. to expect the unexpected;
4. that the occurrence of black swan events are growing in frequency; and
5. with rapidly changing conditions, investors can't change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.
It is important to note that my surprises are not intended to be predictions but rather events that have a reasonable chance of occurring despite being at odds with the consensus. I call these "possible improbable" events. In sports, betting my surprises would be called an "overlay," a term commonly used when the odds on a proposition are in favor of the bettor rather than the house.
The real purpose of this endeavor is a practical one -- that is, to consider positioning a portion of my portfolio in accordance with outlier events, with the potential for large payoffs on small wagers and investments. If I succeed in making you think (and possibly position) for outlier events, then my endeavor has been worthwhile.
How Did My Surprise List for 2014 Do?
In 2014 my success rate was at about 40% (which included five also ran predictions), in line with my historical average but in contrast with my 15 surprises for 2013, which had the poorest success rate since 2005's list (20%). By comparison, my 2012 surprise list achieved about a 50% hit ratio, similar to 2011. Click here to the last slide to see a report card of my 15 surprises for 2014 (and the five "also ran" surprises).
What Was the Consensus for 2014 and What is the Consensus for 2015?
"The only thing people are worried about is that no one is worried about anything.... That isn't a real worry." -- Adam Parker, chief U.S. strategist at Morgan Stanley
"In ambiguous situations, it's a good bet that the crowd will generally stick together -- and be wrong." -- Doug Sherman and William Hendricks
As mentioned earlier we entered 2014 there was a generally upbeat outlook for global economic and profit growth as well as upbeat prospects for the U.S. stock market. Projections for bond yields were universally for higher yields throughout the year -- the same could be said for the general expectation of rising oil prices. As is typical, most sell-side projections for earnings, the economy, bond yields and stock prices were grouped in an extraordinarily tight range.
• Both U.S. and global economic growth disappointed the consensus (despite a strong third-quarter 2014 U.S. GDP print).
• S&P earnings were a slight beat but only because of more aggressive than anticipated share repurchase programs, lower depreciation and interest expenses and a decline in effective tax rates.
• Bond yields declined unexpectedly -- the ten year yield dropped from 3.05% to about 2.20%.
• Deflationary forces were also a surprise -- most notably no one projected that oil prices would fall to under $60/barrel and that the Bloomberg Commodity Index would hit a five year low in Dec. 2014.
• Stock prices ended the year about five percent above beginning-of-the-year consensus forecasts.
Virtually all strategists are now self-confident bulls, as gloom-and-doom forecasts have all but disappeared. After another year with no reactions of 10% or more, any future setbacks are being viewed by the consensus as "bumps in the road" and as opportunities to buy because (after the correction(s)) we will be "up up and away."
After missing the 25% rise in valuations in 2013 (and a further expansion in price-to-earnings ratios in 2014), the consensus now assumes that valuations will expand slightly again in 2015. (Note: The average price-to-earning ratio has increased by about 2% per year over the last 25 years.)
The domestic economy has forward momentum (as witnessed by 5% Real GDP growth in the third quarter of 2014) -- so the extrapolation of heady growth is now in full force by the consensus.
In terms of the markets, the consensus remains of the view that liquidity (albeit, at a slowing rate) will overcome complacency and valuations again as it did last year, but my surprises incorporate the notion that the extremes that exist today (in price and bullish sentiment) put the markets in a different and less secure starting point in 2015.
"We expect the growth recovery to broaden as global growth picks up to 3.4% in 2015 from 3% in 2014. Inflation is likely to remain low, in part due to declines in commodity prices, and as a result monetary policy should remain easy. We think this backdrop supports a pro-risk asset allocation." -- Goldman Sachs, Global Opportunity Asset Locator (December, 2014)
As we enter 2015, investors and strategists are again grouped in a narrow consensus and expect a sweet spot of global economic corporate profit growth that will translate to higher stock prices.
The consensus is for U.S. economic growth of 2.5% to 3.25% Real GDP, bond yields to be 50-to-75 basis points higher than year-end 2014 and closing 2015 stock market price targets to be up by about 8% to 10% (on average). Indeed, most strategists suggest (in sharp contrast to their views 12 months ago) that the big surprise for 2015 will be that there is upside to consensus economic growth and stock market price targets.
Here were Goldman Sach's views for 2014 made twelve months ago (with actuals in parentheses). As can be seen, the brokerage's growth forecasts for the real economy (as was the entire sell side) were too optimistic, while price targets for the S&P Index were not ambitious enough:
• U.S. real GDP was estimated at 3.1% for 2014 (2.4%);
• Global real GDP was estimated at 3.6% for 2014 (3.0%)
• S&P 500 earnings-per-share -- $116 top-down estimate and $119 bottom-up estimate for 2014 ($119 share)
• Year-end 2014 S&P 500 price target was estimated at $1,900 ($2,080)
• Inflation/headline CPI, 1.5% for 2014 (1.1%)
• U.S 10-year Treasury yield 3.25% for year end 2014 (2.20%)
Again, let's use Goldman Sachs' principal 2015 views of expected economic growth, corporate profits, inflation, interest rates and stock market performance as a proxy for the consensus for the coming year. This year the brokerage, like most, is following the bullish trend and is more optimistic on the market relative to their uninspiring expectations last year:
• 2015/2016 U.S. Real GDP growth: 3.1%, 3.0%
• 2015/2016 Global Real GDP growth: 3.6%, 3.9%
• 2015 S&P 500 operating per share profits: $122/share
• Year-end 2015 S&P 500 price target: $2,100
• 2015 Consumer Prices: 1.0%, 2.4%
• 2015 closing yield on the U.S. 10-year Treasury note: 3.00%
The Rationale Behind My Downbeat Surprises for 2015
There are numerous reasons for my downbeat theme this year. Below are a few (in no order of importance): corporate profit margins remain elevated, the rate of domestic economic growth is decelerating (despite five years of QE and ZIRP), a quarter of the world is experiencing minimum growth in GDP, optimism and complacency are elevated, signs of malinvestment are appearing, valuations (price-to-earnings ratios) rose again after a 25% expansion in 2013 (compared to only 2% annual growth since the late-1980s. As well so many gauges of valuations are stretched (Market Cap/GDP, the Shiller price-to-earnings ratio, and many others).
Above all, I expect the theme of the U.S. as an "oasis of prosperity" will be tested in 2015 and 2016.
Moreover, given the large array of potentially adverse economic, geopolitical and other outcomes - the markets have grown complacent after a trebling in prices over the last five years.
Finally, my downbeat surprises this year recognize, that as we enter 2015, we should not lose sight of the notion that if pessimism is the friend of the rational buyer, optimism is the enemy of the rational buyer.