This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by K. Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.
The U.S. stock market finds itself in rare territory as we enter 2015. For only the sixth time in the past 150 years, the U.S. stock market has registered a double-digit gain for three consecutive calendar years, from 2012 to 2014.
We enter the New Year with an overall bullish view, but it is no layup, and there are a number of risks that could derail the market’s historic run. Over the long term, we believe we are in a secular bull market in stocks, and that helps to give a framework around where we see opportunity and risks.
Historical tendencies suggest 2015 could be a very good year. However, it’s hard to get overly bullish given the many risks we see on the horizon. For example, since 1875, the S&P 500 has only rallied seven-consecutive years once—from 1982 through 1989—when it advanced for eight-consecutive years.
The current bull run is almost six years long, and much older than the 3.8-year average of bull markets dating back to 1932. In addition, with the S&P 500 trading at a price-to-earnings ratio of 18, multiple expansion seems unlikely, and further gains will largely depend on earnings growth.
Economy Is Strengthening, But Risks Are Higher
Fortunately, valuations can remain stretched for extended periods and we do expect another positive year of earnings growth on the heels of a strengthening U.S. economy. We expect U.S. economic growth of 3.0 percent, which would be the strongest annual growth rate since the recession, while the global economy should grow by about 3.5 percent.
The major drivers of returns for the market in 2014 were a continued improvement in the U.S. economy, a commodity collapse and the ending of quantitative easing in the U.S. Performance in 2014 was very mixed, and dominated again by large-cap U.S. stocks.
The S&P 500 Index gained 13.66 percent, giving the impression that 2014 was a banner year for stocks. However, a closer examination shows that most markets struggled in 2014.
The average stock in the Russell 3000 Index was up only about 4 percent and the median stock was actually down! U.S. small-cap stocks were only up 4.89 percent, international markets declined across the board, with the MSCI EAFE Index down 4.22 percent and emerging markets losing 2.11 percent.
The return profile in 2014 was so mixed that investors who prudently diversify may feel like they missed the boat. The average broadly diversified portfolio was up in the 5 percent range.
Market Highlights From 2014
Some interesting facts about last year that highlight the disparity of returns across asset classes:
- S&P 500 up at least 10 percent for third year in a row. That’s the longest streak since the five-year streak of 1995-1999.
- Largest S&P 500/EAFE performance spread since 1997
- Largest Russell 1000/2000 performance spread since 1998
- U.S. dollar had its best year since 1997
- S&P GS Commodity Index second-worst year on record
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.