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“It depends” is almost the right answer in any big question.”
~ Linus Torvalds, Software Engineer
THE YEAR IN BRIEF: The year closed with a domestic economy that looked on solid footing with slightly higher than anticipated growth. Employment numbers looked better, consumers were spending more, and corporate earnings remained solid. We have consistently said in our commentaries that in the end the markets aren’t driven by sentiment and headlines but by the “Big E’s” – economy and earnings. One would then surmise that the markets should have had a banner year. Let’s take a closer look at the numbers to see if that was really the case.
Returns tended to reflect the “Big E’s”. Many U.S. large companies that comprise the S&P 500 index benefited from the stronger than anticipated economy and had solid earnings once again. But there is a marked difference between a stronger than expected economy and one that is robust and growing. Domestic GDP growth in the 2% to 3% range is not indicative of a truly vibrant and growing economy. In a low interest rate and low inflation environment, however, it is solid albeit slow growth and a clear indication that a new recession is not likely imminent even as the Federal Reserve continues its easing policy. As the chart shows, the strength in the large company sector, however, did not trickle down to smaller companies during 2014. In addition, the worldwide economic news was not as bright as here at home. Europe and much of Asia saw a year of minimal or no economic growth and market returns reflected that “Big E”. Emerging market economies continued to show growth but not at the pace expected and the market returns in those regions overall reflected that lackluster growth. Lastly, most commodities suffered through a horrendous year with the major metals and energy related products incurring large losses. So was 2014 truly a good year for the market? It did “depend” on which market and which sector.
PORTFOLIO RETURNS: Returns in portfolios with equity holdings were lower than one might have expected given the strong performance of the S&P 500 Index. There were two principal reasons for the lower portfolio returns. The first is asset allocation. Even in our most aggressive asset allocation model portfolio, U.S. large cap stocks comprise less than 35% of the portfolios’ overall holdings. The remaining equity holdings are in sectors that had much lower and even negative returns for the year as one can see from the above chart. All other managed portfolios, including Morningstar’s “Target” asset allocation portfolio models used to set the allocations for our managed retirement accounts, have a U.S. large cap stock weighting of 30% or less. The second reason is the lackluster performance of actively managed stock mutual funds in 2014. Over a ten year time frame, over 60% of actively managed large cap stock funds outperformed the S&P 500 index. Last year, less than 20% outperformed the index. One can find similar performance history and results in other market sectors. The strong market performance during 2014 was driven by specific market sectors including healthcare, technology, and utilities. Other sectors, such as energy, consumer cyclical, and basic materials, were very weak. Funds that were weighted toward the weaker sectors had performance that lagged the market. The combination of portfolio asset allocation and individual fund performance all contributed to last year’s disappointing portfolio performance. Typically, underperforming funds with strong long-term performance histories rebound as changes in the economy bring those currently weaker sectors back into favor. There is no reason not to expect such a rebound over the next year or two with the current portfolio holdings.
DOMESTIC ECONOMY: The U.S. economy seems to be on relatively solid footing as we head into 2015. Both unemployment and the overall jobless (U-6) rate declined slightly during the quarter while job creation picked up and hourly earnings rose. November in particular was an outstanding month for job creation with the economy adding 321,000 new jobs, 86,000 of them in the professional and business sectors. Gas prices fell both unexpectedly and dramatically, saving households over $14 billion during the quarter. The combination of those factors along with increased confidence in the economy led to more consumer spending. Meanwhile, inflation remained historically low and the year-to-year CPI increase as of November was only 1.3%. Turning from the consumer to the producer, both the PMI Producer Price Index and the ISM Services Index indicated continued sector growth. Real estate was the most disappointing sector during the quarter. Although mortgage rates continued to remain under 4%, both existing and new homes sales as well as new permits were off during the fall.
GLOBAL ECONOMY AND MARKETS: The plunge in oil prices put further pressure on Russia’s economy that was already weakened due to sanctions for its activity in the Ukraine. It appeared to be a nation headed toward recession as the stock market floundered as did the ruble, which by year-end had lost half of its value against the dollar this year. In the European Union, Greece was back in the headlines as Parliament was dissolved after it was unable to elect a new President. Indications were that the Syriza party may be poised to win the upcoming national election. The party, however, has long opposed the austerity conditions that were part of the nation’s recent bailout package and vowed to overturn much of those economic measures once in power. As for the broad EU, job creation continued to be an issue with the unemployment rates at 11.5%. Overall, the economies of the region showed minimal growth (.8%) and the Euro was approaching a 9 year low against the dollar. Across the globe in China, the economy there continued to slow and real estate continued its downturn. It appeared that China’s growth for the year would be under 7.5%, the worst year for its economy since 1990, although that type of growth appears very strong compared to the rest of the world.
A LOOK AHEAD: Waning oil demand seemed to trigger the early year market sell-off and increased market volatility. There are clearly some headwinds worldwide as 2015 begins. European economies continue to struggle and the potential for a new monetary crisis in Greece appears to be closer. Russian economic woes could have a ripple effect in the region and raise the possibility of a new round of geopolitical issues as leadership attempts to deflect the nation’s true problems. The slowdown of growth in Asia and emerging countries will impact those regions. Finally, continued unrest throughout the Middle East always raises the potential to disrupt the world economies and markets. That being said, the U.S. still appears to be the best house in a bad neighborhood mainly because of the “Big Es”. The economy continues to grow albeit somewhat modestly. Early indications are that corporate earnings will reflect the continued economic growth. The market may get continued help from the Federal Reserve as well. In its December 17th policy statement, the Fed declared it would be “patient in beginning to normalize the stance of monetary policy”. In short, it appears that any rise in interest rates may still be some time away. So where does that leave us for 2015? There is a good possibility that the upcoming year might look very much like the last one with low interest rates, low inflation, and solid but not spectacular market returns. The one difference in market returns from last year might be some rotation in the strength of various market sectors. Large cap stock returns may well lag other asset classes. Once again, we remind investors to keep in mind the “Big Es” and not get caught up in the emotion of any daily headlines and market volatility. Hanging on and settling in for the ride has always proven to be the best course of action to follow.
Please note: Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.