The Palantir - Vol 3 Issue 1
The Road to Oz by Bryan C. Taylor, CFA
“A place where there isn’t any trouble. Do you suppose there is such a place, Toto? There must be. It’s not a place you can get to by a boat or a train. It’s far, far away. Behind the moon, beyond the rain…” Dorothy, The Wizard of Oz
Growing up we had one of those old analog TVs. You know, the kind where you turn the knob and the picture kind of warms up after the TV has been on a while. This really was our best TV because it was color. We also had a tiny black and white version, but, of course, no one wanted to watch anything on that. Such scenes seem worlds away from the fast paced 21st century world of today with its high def, crystal clear, digitally enhanced viewing experience. And yet some timeless classics like the Wizard of Oz remain…ingrained in our memory and still available although often “remastered” with new color saturation and digitally enhanced sound. I began thinking about Oz because it often came on in the spring each year when I was a child. Thinking about it reminded me, in many ways, of the current economic environment and its effect on today’s financial markets. I’m sure many of you are thinking, “The old boy’s lost it for sure this time!” How could one possibly tie the Wizard of Oz to the modern economy and the stock market? After all, it was produced in 1939, and it is a fantasy story…hopelessly out of date…or maybe not.
One could consider the world economy to be a bit like Dorothy and her companions skipping their way down the yellow brick road to Oz. Dorothy would, of course, be the U.S. economy leading her compatriots to see the Wizard. We might say at this point in the journey, the European Union is a bit like the Tin Man…it has clearly lost its heart, and the Japanese economy with its aging population under the fanatical easing of Shinzou Abe could easily pass as the Cowardly Lion having lost its courage. Perhaps with a bit of a mental stretch we imagine China as the robust Scarecrow who struggles a bit mentally. Of course, we can’t forget Toto that wonderful dog of a U.S. market who happily bounces along ahead of Dorothy!
Now that you have the analogy firmly in your mind, I am certain you can easily guess the identity of the Wizard of Oz…exactly, the Fed. The carefree companions continue on their journey to Oz certain that the Wizard will give them their deepest desires. Along the way they battle the Wicked Witch of the West which I am sure you recognize in its modern deflationary form. They are assisted by the beautiful Good Witch of the North who in her inflationary capacity (I mean she travels around in a bubble for pity’s sake!) is clearly in league with the wonderful Wizard of Oz but can’t quite seem to bail all of the companions out of the difficulties of their journey. However, our merry band remains certain that if they can just get to Oz, the Wizard will heal their ills and give them what they lack…alas, when they finally reach the Emerald City and meet the great and powerful Oz…good old Toto exposes him for the fraud that he really is. And his powers…well they leave a bit to be desired. Maybe the analogy is just a little too accurate after all particularly if you are an economist from the Austrian School.
Like Dorothy on her journey, the U.S. economy has continued to improve over the last few years, and 2014 was no exception. Unemployment continued its gradual decline dropping over one percentage point to end the year at 5.6%. Despite a poor showing in quarter one, U.S. GDP rallied throughout the remainder of the year with the third quarter report revisions bringing the final number to 5%, an 11-year high. Manufacturing improved, consumer sentiment improved, and the dollar rallied…all led by Toto (the U.S. Stock Market) which continued to march ever higher. The Dow set a new all-time high of 18,053 on December 26 and finished the year at 17,823 with a total return slightly over 10%. The S&P 500 did even better finishing the year up approximately 13.7%. Unfortunately, diversified portfolios were held back by the poor showing, in U.S. Dollar terms, of developed international and emerging market equities which both ended the year in the red. Weak returns in small cap equities compounded the challenge. Further, while the Barclays Aggregate index provided solid fixed income returns, both the short end of the curve and more risky elements of the bond market reduced many portfolios’ overall returns. These issues, along with a poor showing by most active managers, led to fairly modest returns for globally diversified portfolios.
Despite the final removal of QE (Quantitative Easing) by the U.S. Fed early in the fourth quarter, the global monetary wizards remained largely accommodative. U.S. interest rates remain pegged at zero, the government of Shinzou Abe has continued to print yen at a frenetic pace, and the EU is considering its own QE program to provide additional assistance to the beleaguered currency zone. Given recent comments by the U.S. Fed and the steadily rising dollar, we now believe it remains unlikely that the Fed will begin raising U.S. interest rates until later in 2015.
A strong showing by the Republican Party at the polls in November should help ensure that fiscal policy remains accommodative. While it is unlikely, in our view, that significant legislative change will result from the recent elections, we remain hopeful that the Republican majority will, at least, be able to forestall any anti-business legislation. As indicated above, the U.S. economy continues to grow and is currently buoying a more gloomy global economic backdrop. However, with central banks remaining extremely accommodative in 2015, we view the global economic environment as benign and the U.S. economic environment as quite positive.
In our view, U.S. equity valuations remain somewhat stretched, and in some respects this view may prove cautionary to further equity price appreciation. However, given solid corporate earnings, an accommodative Federal Reserve, a growing U.S. economy, and falling oil prices, it is likely that stock prices will continue to appreciate throughout 2015. The removal of QE and the relatively high valuation ascribed to U.S. equities will, in our view, lead to greater volatility, but we still expect that domestic equites will end 2015 on a positive note.
The U.S. consumer may finally be shrugging off the lingering effects of the Great Recession. The recent fall in oil prices coupled with an improving job market have helped improve consumer sentiment. It is important to note that the U.S. economy is largely consumer driven, and while we are hesitant to sound the “all clear” signal, there is no question that the mood on Main Street has improved.
As we write, 2015 is off to a somewhat inauspicious start. One would do well to remember that the monetary wizards can only do so much and when the curtain is pulled away the results may be less spectacular than expected. There are often adventures on the yellow brick road to Oz…at least one resulted in Toto spending some time in a cage! Hopefully, we’ll enter the Emerald City at the end of 2015 on a positive note, the deflationary witch melted, and her inflationary counterpart well in hand, but there are sure to be some challenges along the way, and I am sure like Dorothy we’ll find ourselves saying, “We’re not in Kansas anymore!”
Financial Advisory Consultants DBA/Cornerstone Management Inc. is a Registered Investment Advisory Firm. Although the information in this report has been obtained from sources that the Firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.