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Understanding Valuations ‘Cardinal Rule’ of Investing: JPMorgan’s Kelly

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2015 was a year of “intense frustration,” David Kelly, chief global strategist for JPMorgan Asset Management, said on a call on Tuesday. Oil was too low and the dollar was too high; China and Europe caused investors concern, as well as a potential government shutdown in the United States, not to mention uncertainty over when the Fed would raise interest rates.

“It was just confusing for a lot of people. I think all that confusion caused people to hesitate to invest,” Kelly said, which led to a “miserable year” for total returns.

Kelly said there was almost $12 trillion in savings accounts, including CDs and IRAs, and money market funds last year. That’s about $37,000 for “every man, woman and child in America,” he said. The money sitting in cash is not good for the economy, for clients or for advisors, he said. “The real question is how can we give investors the courage to invest properly and the understanding to invest properly this year?”

Kelly said investors this year need to understand what’s going on with energy, China, the dollar, the Fed, and then “take a look at valuations. The cardinal rule of investing is make sure you look at valuations,” he said.

Oil ‘All About Supply’

Kelly acknowledged that he didn’t think oil would be lower at the end of 2015 than it was at the beginning. The problems in that sector are with supply, not demand, he noted. Between 1996 and 2013, the average annual growth rate of global oil consumption was 1.4% per year. Projections from 2013 to 2016 come out to the same rate, he said.

“There hasn’t really been any change in consumption,” he said. The problem is a surge in oil inventory, and problems at OPEC.

Kelly said that when prices were falling during the November 2014 meeting of OPEC, the organization declined to cut production. “What was going on at the time is that OPEC was falling apart,” he said. “There’s a blood feud between the Sunni and the Shiite, between Saudi Arabia and Iran.”

He compared the situation to the movie “War of the Roses,” where the protagonists would rather suffer themselves than let the other go unscathed. He said Saudi Arabia and Iran will “beat the tar out of each other in a proxy way.” 

He expects production will continue to fall, “quite significantly,” he said, while consumers increase consumption. “People are basically wasting energy because it’s cheap,” Kelly said.

He said it’s difficult to predict the price of oil (although he did say he expects it to be between $45 and $50 a barrel), even with surplus OPEC production, the increase in consumer demand will eventually “mop up inventory surplus and push prices up a bit.”


China’s economy is slowing, but it’s hard to tell how much as “the Chinese economic numbers are fake,” Kelly said. The renminbi is too high to support exports, the housing market is overbuilt and there’s a long-term debt problem the country will have to face.

“They’ve got a lot of problems,” Kelly said of China.

Add to that the “spectacle of global markets freaking out” last August due to volatility in China. He called Monday’s market drop an “aftershock” of that.

The good news is that these problems can be managed, he said. The People’s Bank of China can adjust the exchange rate any way it wants, Kelly said. Furthermore, the Chinese government can stabilize the stock market.

“They have a will and a way. In the U.S., there’s not much will and there’s not much way. The government doesn’t have really any authority or will or desire to manage the stock market on a day-to-day or hour-to-hour basis.”

Even if the U.S. government wanted to do so, total stock market capitalization in the U.S. is about 100% of GDP, compared with 13% in China.

Corporate Profits

The big problems for corporate profits last year were the growth of the dollar and the drop in energy prices, Kelly said.

The dollar was up about 16% year-over-year in 2015, Kelly said, which took about 6% out of S&P 500 profits. In 2011, the energy sector was responsible for about 11% of S&P 500 earnings, while in 2015, it accounted for -1%.

“That’s a 12% swing. We lost 6% to the dollar. We lost 12% to energy,” he said. Kelly believes earnings will be down about 6% for the year. “Frankly, that’s a win given the headwinds that we faced.”

If the dollar remains where it is throughout 2016, it could only have a 1% drag on corporate earnings. Similarly, if energy earnings are 0% in 2016, it’ll result in 1% higher operating earnings than in 2015.

“Net, we could be in a position where oil and the dollar took high single digits out of earning growth in 2015 and takes zero out of earnings growth in 2016.”

The Economy and the Fed

“I know the economy is only growing by about 2%,” Kelly noted, but only needs to grow by about 1.8% in the long run. That 2% is outperformance, he said, not underperformance.

“Twenty years ago, if the U.S. economy was growing by 2% a year, it was a sign that it had a problem. Today, that’s better than it’s going to be able to do in the long run. It’s not a good outcome, but it doesn’t say that we’re facing some recession.”

Kelly said he expects about 2.5% growth from the fourth quarter of 2015 to the fourth quarter of 2016. Consumer spending should improve this year, he said, as will investment spending, government spending and housing.

Unemployment is expected to fall as well, and faster than the Fed expects, according to Kelly. If the 2.5% growth rate plays out, he expects unemployment will be down to around 4.3% or 4.4% by the end of the year, and be under 4% by the beginning of 2017.

If the unemployment rate comes down faster than the Fed thinks, there could be four rate hikes this year.

As uncertainty over Fed action shifts from whether it will raise rates to how much it will raise them, investors are wondering if four rate hikes is too many. Kelly says no. “If you look back over the last five rate-hike cycles,” he said, “the Federal Reserve increased interest rates at an average rate of 2.5% per year.”

The proposed rate now is about 1% per year, Kelly said, just 40% of the historic pace.

“Are they going to do it?” he asked. “It’s a close call, and please don’t bet the bank on this one, but I think the Federal Reserve will probably do it.”

Chair Janet Yellen is very dovish, Kelly said, and the Fed has been skittish about raising rates in the past. However, there’s been a “changing of the guard” with new hawks joining the bank, Kelly said, who want to move rates up: Loretta Mester, Esther George, Jim Bullard.

Ultimately, “if you have a recession down the road, you need to be able to cut rates to help, and you can’t cut rates from zero.”

Global Economy and Emerging Markets

Trouble in international investments over the last two years has come down to the dollar, Kelly said. At its current level, the U.S. is running a 2.7% current account deficit, he said. “We’re buying everyone else’s stuff because it’s cheap. They don’t want to buy our stuff because it’s expensive.”

That’s causing a surplus of U.S. dollars in the world market, he said, which should push the dollar down, but “today there are so many financial market speculators involved that it tends to muddle that signal.”

The global economy overall is dominated by older economies, with low growth in labor supply and productivity, he said. “People shouldn’t freak out about slow global growth; that’s the world we live in.”

Falling commodity prices are a sign of weakness in some markets and a cause of weakness in others, Kelly said. The question for investors in emerging markets in 2016 is whether they are producers or consumers of commodities. “I think you have to look at that question and other parts of emerging markets and valuations to make good emerging market decisions.”

— Read El-Erian: 5 Facts About the Market Selloff on ThinkAdvisor.


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