Unknown Unknowns

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.

I remember back in 2002, listening to Secretary of Defense Donald Rumsfeld make that statement about the Gulf War, yet thinking how appropriate it was for the ever-changing financial markets.  Far from an exact science, managing portfolios involves making predictions about the future, while balancing the risk/reward tradeoffs in every decision.

Every year, around this time, the pundits offer predictions about the economy and markets for the upcoming year.  Historically, their forecasts, more often than not, prove well off the mark.  2014 was no exception, particularly in two areas.  First, the mean estimate of market strategists called for about an 8% advance in the overall stock market.  Stocks did significantly better than that.  Second, the median forecast for the price of oil was around $98/barrel.  The actual price at year-end was about $40 less.

Now most strategists, economists, as well as individual investors understand how difficult forecasting is when it comes to the economy and markets.  But this never prevents them from being made.  Forecasts can be helpful in developing investment strategies if they are used with the understanding of how potentially inaccurate they may prove to be.

On to 2015…
As we enter the New Year, strategists are overwhelmingly bullish on stocks.  With history as a guide, this makes me nervous.  The overall stock market has advanced for six consecutive years. What are the odds that it can climb for a seventh year in a row?  In recent times there have been two periods were stocks advanced for extended periods – the eight years 1982-1989 and the nine-year run 1991-1999.  So, if this recent bull market continues in 2015, it would not be unprecedented.

Low interest rates, benign inflation, and a growing domestic economy are the underpinnings of this consensus bullish outlook.  However, these trends have been in place for some time, which means they may be largely discounted in current stock prices.  Valuation analysis would seem to support this concern.  The Price/Earnings (PE) ratio for the overall market is currently at 16.2, well above the 11.0 PE level at the start of the bull market in early 2009.   At the same time the current market PE is well below the PE of 24.0 when the market peaked in 1999, although it is slightly ahead of the PE of 15.0 reached by the market toward the end of the bull market in the 1980s.  What does this all mean?

As long as…
As long as the major drivers of the market remain in force, low interest rates, benign inflation, and a growing domestic economy, the outlook remains positive for stocks.  So, let’s try to challenge each one.

First, interest rates are at historically low levels, with the 5-year and 10-year US Treasury bonds yielding 1.2% and 1.7%, respectively.  The Fed will likely raise interest rates sometime in 2015, but rates will rise very slowly, and this is unlikely to change the course of the overall economy.  Second, core inflation is running around 1.6%, and with the recent decline in oil prices, and struggling economies in Europe, Japan, along with a slowdown in China, the prospects for acceleration in inflation are low.   Third, most indicators forecast an uptick in domestic economic growth, driven largely by lower oil prices, which should bolster consumer spending.

The main risk to these three important market drivers is an exogenous shock from a sudden geopolitical event.  Unfortunately, these are impossible to predict.  We may be convinced that something is going to happen but we can’t know when.  Investors, on a global basis, deal with this lingering uncertainty by purchasing US financial assets.  The higher the degree of concern the higher the demand is for the relatively safe haven of US stocks and bonds.  That might sound simplistic, and perhaps it is, but it is a powerful force nonetheless.

If and only if…
At the start of this recent bull market, the PE was 11.0, it has climbed to 16.2, and could move higher in this uncertain global environment.  However, there is a limit to how much the PE can expand.  It would be fundamentally healthier for the stock market to be driven higher by accelerating earnings growth, instead of a general flight to quality in the face of global trepidations.  If oil prices stay low, and if tax reform yields lower corporate and individual tax rates, corporate profits might accelerate.  This scenario would likely drive stock prices meaningfully higher.  Conversely, if geopolitical events result in a spike in oil prices, and tax reform fails to materialize, then corporate profits would come under pressure.  Under this scenario, stocks could only move higher driven by a continued flight to quality, essentially stretching the valuation bands and raising the overall risk level of the market.

Focus on fundamentals…
Focus on what you can control
 might be the optimal strategy for 2015.  For us that means working our analytical process relentlessly in order to accurately identify industry-leading companies that have sustainable competitive advantages over their peer group.  If we can do that successfully, over the long run, we won’t have to worry so much about the unknown unknowns.