Our baseline expectations for the market in 2015 call for additional gains. Our year-end target for the S&P 500 is 2,275, which would be about a 10 percent gain.
Those expectations are based on analysis of historical precedence, including the average market gains in the third year of the presidential election cycle, strong momentum, earnings growth, seasonal trends, accelerating economic growth, and the normal market performance around the first Fed rate hike.
Small-cap stocks underperformed large-cap stocks by 877 bps last year—which we noted earlier was the largest spread since 1998. Small-cap stocks should post a countertrend rally on a relative basis compared with large caps.
After a dismal 2014, small-caps are oversold relative to large-caps. In addition, the four-year presidential cycle is bullish for small-caps into mid-2015, and accelerating U.S. economic growth is also a positive factor for small-caps.
Qualify Concern About Fed Tightening
The Fed appears to be on track to raise short-term rates to above zero percent for the first time since December 2008. In our opinion, the rate hike is likely to come at the June FOMC meeting. History suggests that a rate hike is not a death sentence for the market.
In the 13 cases since 1928 in which the Fed embarked on a rate-hike cycle, the S&P 500 climbed an average of 9.8 percent during the 12 months spanning the six months before and six months after the start of a tightening cycle. That said, the gains have been stronger before the hike than after it.
Beware Stretched Valuations
Our single-biggest concern continues to be stretched valuations, which suggests there is little room for multiple expansion. However, valuations are not very good timing-tools and can remain stretched for extended periods.
Adding to the concerns about valuations is that by historical standards, the current bull market is no spring chicken.
It began in March 2009, and at 5.75 years of age, it is longer than the 3.8-year average bull market duration of the past 80 years. And only three of the past 15 bull markets since 1932 have lasted longer than the current bull market. Fortunately, bull markets don’t die from old age, and investors have profited mightily during this run.
However, the age of this bull market does suggest risks are rising, and that to expect it to last much longer without a cyclical downturn would be stretching historical probability.
Both Active And Passive Required
Throughout 2014, a debate raged about the merits of active versus passive investing. We engaged in the debate by writing several articles on the subject that appeared on ETF.com. As active managers, we believe active strategies can reduce risk and add alpha over time. That said, we do subscribe to both styles, and believe both have merits in constructing a robust portfolio.
The above chart shows public net inflows into passive index funds from 1993-2013. As you can see, passive index flows soared in 1999-2000, again in 2007-2008, and now again beginning in 2013 with a record projected for 2014. Through September 2014, nearly all flows have gone into passive index funds. For example, $173 billion net has gone into passive index funds versus only $2.5 billion net into active funds.
Red Flags Surrounding Passive Inflows
This is not an indictment about passive investing; rather, it’s more about where we are with investor sentiment. We view this preponderance of passive inflows as a warning sign that it is a crowded trade, and that can pose serious risks for the market.
The prior times when passive net inflows really soared, the market suffered thereafter. Of course we were in the midst of a secular bear market in stocks then. This time, we believe the secular trends are a tail wind for stocks. Nonetheless, it is something to keep close watch on.
Long-term historical trends and a strengthening economy suggest 2015 has the potential to post robust gains. However, it’s not a layup by any means. As far as that goes, we believe investors in passive allocations will benefit from blending in an active approach to tactically manage risk and identify opportunities across the markets.
Clark Capital Management Group is an independent investment advisory firm providing institutional-quality investment solutions to individual investors, corporations, foundations and retirement plans. Clark Capital was founded in 1986 and has been entrusted with approximately $3 billion in assets. For more information about Clark, contact Advisor Support at 800-766-2264 or [email protected]. Please click here for a complete list of relevant disclosures and definitions.