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Market Insight - January 2015

Despite the mostly gloomy predictions a year ago for both stocks and bonds, U.S. financial markets, equity and fixed income, delivered strong returns once again in 2014.  We made the case in our market analysis last January that accelerating job creation and GDP growth would persist in 2014, and lay the groundwork for meaningful gains in earnings, valuations, and stock prices. This proved to be the case.  The Dow added 7.52% and the S&P 500 11.4% in 2014, in spite of a sharp pullback in the fall that nearly wiped out all the year's profits. Smaller company stocks, measured by the Ishares S&P Small Cap 600 index (IJR) rose by 5.88%, recovering from a near bear market decline in September.

There were several surprises, the first of which was the accelerating strength of the U.S. economy itself. The reality of U.S. GDP growth certainly played havoc with the economists, whose consensus forecasts at the beginning of 2014 for a leveling off of economic gains proved painfully inaccurate;  the GDP grew over the last two quarters at 4.6% and 5% annualized, respectively, providing more than adequate fuel for market gains. 

Next, the precipitous decline in the price of oil, by over 50%, to less than $55 a barrel. 

 Falling commodity prices are indeed a two edged sword. They provide a meaningful benefit to consumers and users, but put pressure on the massive global energy infrastructure, particularly those regions and countries that depend heavily on oil revenue. While wide swings in commodity prices tend to self-correct over time, an extended slump in energy prices could pose a strong headwind for equity performance, as slackening demand is seen as a symptom of a global slowdown.

Yields in fact fell dramatically; the benchmark 10 year bond settled at around 2.2% by year end 2014
 

Finally the continued strength of the U.S. bond market,  This time last year we felt that the 10 year bond, then at 3%, represented good value, even as the noisy bond bears continued to call for a collapse of prices. Yields in fact fell dramatically; the benchmark 10 year bond settled at around 2.2% by year end 2014, and fixed income investments provided a meaningful contribution to portfolio gains.  The IShares 7-10 year Treasury Bond index (IEF), measuring performance of the benchmark bond, gained over 9% in 2014. While credit concerns held the high-yield corporate sector to very minimal gains, tax free investors, both investment grade and high yield, did much better. The Vanguard High Yield Tax Exempt Fund (VWAHX) gained 11.62%, while the Vanguard Intermediate Term Investment Grade Tax Exempt Fund (VWITX) added 7.25%. 

International investments in 2014, however, proved a disappointment. A stronger dollar, ongoing economic stagnation in Europe and Japan, and a slowdown of growth in China impacted returns. Developed markets, measured by the MSCI EAFE etf (EFA) fell 5.04% for the year, while the MSCI EAFE developing market etf (EEM) lost a little more than 1%. The strongest asset class in 2014 was real estate; real estate investment trusts, measured by the Cohen & Steers Realty fund (CSRSX) gained a staggering 30.18%.

Outlook for 2015
 

Global growth outside the U.S. now depends considerably on the success of both the Eurozone's proposed quantitative easing program, and Japan's efforts to stimulate its moribund economy. Europe has turned away from a mostly ineffective policy of austerity put in place after the recession of 2008; time will tell if it's a case of too little and too late. Japan, among other things, is struggling with demographics, an aging population that clearly prefers saving to spending. While it may take some time to work out, the numbers tell us quite clearly that investments in International markets following a period of underperformance tend be rewarded, and we are positive on this asset class.

As we bring 2015 into focus, we see an increasingly earnings driven market for U.S. stocks; that is to say, earnings expectations and surprises, both good and bad, will move markets more in 2015 than in the recent past, and probably result in greater volatility as well. Equities are trading at slightly higher than average price earnings ratios, based upon trailing earnings, and are no longer inexpensive from a valuation standpoint. Fixed income investments, 

which typically represent between 30-50% of our clients’ portfolios, seem to have incorporated the Fed's planned normalization of interest rates; still, if longer term rates do rise it will  present a challenge to fixed income returns. Bond investors have begun to realize that inflation expectations, rather than the Fed's raising of short term rates, represents the real worry. Neither complacency, nor misdirected fearfulness, belong in the bond buyer’s vocabulary.

Our investment approach, balanced and global, makes use of index investments, ETFs, individual bonds and bond funds, with allocations among these areas reflecting the unique needs and circumstances of each client and family. We have moderated our total return expectations for 2015, but still expect performance that would be consistent with our clients' long term goals.

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