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VOL. 38 | NO. 51 | Friday, December 19, 2014

Fear drives US stocks higher

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In 2014, more than 600 hedge funds have disbanded. Even accounting for the carnage of 2009, this amounts to a record pace of “smart money” failures.

In the more pedestrian mutual fund realm, active money managers are having their worst year ever of relative performance.

With all of the money, time and energy, MBAs, CFAs and the like have dedicated to honing their investment capabilities, what explains the sudden broad based collapse of investing acumen?

Consider this potential essay question:

At the end of 2013, the 10-year Treasury bond yields 3 percent. By year end 2014, the economy will shift to above 4 percent GDP growth. Job growth in the U.S. will accelerate to its fastest pace in 15 years. Equity market valuations enter 2014 at elevated but not unreasonable levels. Corporate profits and margins will hit record highs.

Now, answer following questions and support your arguments: Will interest rates rise or fall in 2014. Which securities should provide the highest returns? Should you overweight cyclical or defensive sectors, small caps or large caps, domestic or internationals?

Most likely, well-studied MBA/CFA candidates would argue for higher rates, higher equity prices and overweights to more elastic securities. Loads of historical evidence and correlations would support them. They’d be wrong.

The 10-year Treasury bond currently yields 2.15 percent, 30 percent lower than it began the year. While the S&P 500 has advanced over 10 percent, the advance has been led entirely by defensive sectors.

Averaged together, consumer staples, utilities, health care and telecoms are up nearly 17 percent year to date. Cyclical sectors including materials, financials, industrials, technology, consumer discretionary and energy have posted average returns of only 1.8 percent.

Likewise, other trusted, pro-cyclical, old-reliables like small-cap and international stocks have year to date returns of 0 percent and -5 percent, respectively.

The queer behavior of the markets this year emanates from global policy divergences. Central banks in Europe and Japan issue dire assessments of the global economy at every opportunity. They have done everything they can to devalue their currencies while frightening constituents.

Conversely, the U.S. Fed broadcasts optimism and has moved its messaging towards “normalization.” Given the fluidity of global capital markets, money has fled the frowny locales for the more cheerful U.S.

The uplift on the S&P 500 reflects the global desire to hold productive dollar-denominated assets. The unusual avoidance of more cyclical areas reflects international trepidations. In short, U.S. investors are frightened, which is why U.S. utilities have rallied 22 percent this year.

Bottom line: 2014 will go down as one of the strangest and most unproductive investment environments for active money managers in history. The hyperactivity and contradictions of global policy makers has led to mass migrations of capital into the U.S. security markets, boosting the dollar, lowering bond yields and elevating stock prices.

However, below the headlines the returns demonstrate more fear than optimism as pro-cyclical investments are flat to down while traditionally defensive assets have soared. Investment textbooks simply lack a chapter that describes such a policy driven investment dichotomy.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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