Bottoms-Down Forecasting

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Griswold, Bottoms-down forecasting

What do bad wiring, methane and non-chloric, silicon-based lubricant have in common?

Presumably a classic Christmas movie would not first come to mind. It’s a Wonderful Life and Miracle on 34th Street, those are true classic masterpieces. In more recent movie history, A Christmas Story and Home Alone have captured the rowdier spirit of the season.

That leaves National Lampoon’s Christmas Vacation a close fifth for some as a must watch, at least among the non-animated classics. Favorite scenes compete for top spot in this less-than-high-brow comedic tale; two of these star animals. In the first, a cat chewing Christmas tree light wires ends fatally for the feline. This side-splitting scene was almost cut by the PC police, which just goes to show you. In the second scene, an indoor squirrel chase also delights; the culmination of a hilarious series of events that features methane gas and Cousin Eddie, perhaps the best redneck character to ever grace, if such terms as redneck and grace can reside together, the big screen.

And then there’s the infamous downhill sled scene. In endeavoring to achieve a “new amateur, recreational, saucer-sled land-speed record,” Clark Griswold, played perfectly by Chevy Chase, waxes a steel sled with a kitchen lubricant. The fiery end in a Wal-Mart parking lot is truly one for the ages. With Christmas being over, it seems a shame to store these moments with everything else that comes out for the Holidays and won’t be seen for another long year.

But look ahead to the New Year we must. Wall Street has been doing just that for the better part of the last month. Barron’s recently characterized the Street’s 2016 outlook as, “Cautious, but Optimistic.” The group’s mean forecast places the benchmark Standard & Poor’s 500 stock index at 2220 by the end of next year, roughly six percent above current levels.

Of course, the optimistic predictions are on par with those being espoused at this time last year that have not panned out as prognosticated. But the optimism is to be expected. With rare exceptions, strategists are a sanguine lot, as they should be. After all, they’re tasked with keeping their firms’ clients’ money fully invested (and therefore fully fee-generating).

Given his constructive posture, Goldman Sachs’ David Kostin is this year’s standout among Barron’s ten cited strategists. His 2,100 yearend S&P 500 target is the lowest of the bunch. His outlook is weighed down by the view that the Fed will hike rates four times in 2016. This will in turn drag down what will otherwise be decent earnings against the backdrop of yet another year of tepid economic growth.

Citigroup’s Tobias Levkovich, a friend and investing legend in his own right, is characteristically optimistic. His Barron’s forecast lines right up with the consensus: The S&P will end next year at 2200. That upbeat take makes his downside risks all the more intriguing as they tap the contrarian in him. Tellingly, they begin with upside risk to the employment and wage picture which triggers a “chase towards higher bond yields.” This chase would catalyze what policymakers fear more than wage inflation; that is wide scale bond fund withdrawals which exacerbate illiquidity and trigger further financial market tightening.

Policymakers have good reason to be concerned: U.S. credit mutual funds have doubled since 2010 and now own a fifth of the market; retail investors have poured over $1.2 trillion into credit mutual and exchange-traded funds since then. The last thing portfolio managers need at this juncture is greater constriction on their ability to trade their holdings.

The real question is whether the long-anticipated rise in wage inflation is really around the corner. That would be a good problem to have for many Americans. While jobless claims would have many believing the arrival of higher paychecks is imminent, layoff announcements are poised to end the year up by nearly a third over 2014. In other words, the lowest commodity prices in 16 years will continue to exact a macroeconomic toll; the damage is unfolding with a lag as many companies (and countries) have banked on a rebound in energy prices.

The conventional wisdom heading into 2016 is that the economy is finally poised to reap the benefits of lower gasoline prices; oil prices have fallen so far they no longer have the ability to do incremental harm. Fresh data on home sales in energy dependent states, though, defies this conclusion as the fallout appears to be intensifying. Punctuating the latest stats on housing, the outlook in the just-released Dallas Fed manufacturing survey tumbled to its bleakest levels of the past year, matching lows last seen in 2009.

Meanwhile in the Midwest, the prognosis for the Chicago region refuses to break into positive territory. This can’t be comforting given the auto sector’s outsized positive influence on the current recovery. The dour outlook does, however, help explain the fact that the number of cars sitting in inventory vis-à-vis sales levels is at the highest since 2009.

The credit markets, for their part, are shooting first and presumably taking questions at a later date. What’s spooked them? In bond land, investors rely on the distress ratio to guide them, that is the number of high yield bonds trading at yields 10 percentage points or more above comparable-maturity Treasury bonds. As of November, one-in-five companies were in this leaky boat, the highest showing since 2009.

The distress ratio is seen as a precursor to the more definitive default rate, when companies actually renege on their interest payments. For now, the rate is just north of three percent, not high enough to set off any alarms. But forecasts are calling for it to push five percent next year fueled by energy company defaults, which are expected to spike to 11 percent.

A bit of context: Though the rate itself will remain historically low, the dollar amount of failing debt is expected to rise to $66 billion, close to 2001’s $78 billion but still a fraction of 2009’s record $119 billion. If only the credit markets existed in a vacuum. Roll the rest of the world’s debt markets into the equation and defaults have indeed risen to the highest level since 2009.

In the event the repeated mention of 2009 has given you a case of the jitters, fear not. At least that’s what New Albion Partner’s Brian Reynolds advises. Reynolds, who tracks public pensions’ penchant for risk taking, provides assurances to the leery in the form of a running tally of pension allocations to credit funds.

Reynolds’ figures grace these pages with frequency for good reason, namely that pensions have a lot more cash to throw around than most – as in $18 trillion. With the latest month’s count in hand, it’s official — pension allocations to credit funds hit monthly records in August, September, October, November and now December. In all, some $175 billion earmarked to fund current and future retirees’ income has flooded credit funds since August 2012. With the trend continuing apace, demand for all manner of credit promises to continue burying supply, propping up a market that should be toppling over.

As simple as the argument is, Reynolds could be on to something. If he’s right, recession may not greet the next president proving the cheery prognosticators at the Congressional Budget Office right. At the start of this year, the CBO predicted that the current recovery would last, at a minimum, through the end of 2017. Maybe the CBO has also been following pension behavior and knows that financial engineering in the New Year will remain alive and well.

If only this could end as well as a feel-good Christmas movie. For now, policymakers are looking the other way. What say could they possibly have in the matter, even if they did acknowledge that pensions are using neither a bottoms-up or top-down methodology to test the appropriateness of their portfolio allocations? Besides, party poopers have no place as New Year revelers gear up for one last hurrah.

But what if 2015 really is akin to 1998, and not 1999, for investors? What if this rally has legs and can keep recession at bay? Well then, we position our collective portfolios to profit at the expense of irresponsible pensions employing a bottoms-down approach, Griswold-style. The fact that they’re placing pensioners’ promised paychecks at grave risk of spontaneous ignition can be relegated to denial-ville as so many seemingly intractable issues are today.

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