A bearish January gave way to modest gains for the major stock market indices in the first quarter of 2015. The Dow Jones Industrial Average added 0.33%, the S&P 500 advanced by 0.95%, and the Nasdaq, focused on technology and biotech stocks, handily outpaced the broader, less glamorous stock indexes, gaining 3.86%. Mid-caps continued their impressive ascent with the Russell Midcap Index up 4.0% during the quarter. Small-caps renewed their winning ways as the Russell Microcap Index advanced by 3.1%. The Russell 2000 Index was the overall leader among the broad-based domestic indexes, adding 4.3%.
Non-U.S. equities performed more in line with their U.S. counterparts for the first quarter. The MSCI Emerging Market Index added 1.91% while the MSCI EAFE Index of developed markets gained 4.19%.
The fixed income markets remained persistently monotonous. Interest rates on 10-year U.S. Treasuries ended the quarter within a couple of basis points of January 1st levels. The Barclay U.S. Aggregate Bond Index rose 1.61% during the first three months of 2015.
Remarkably, the S&P 500 and the Dow Jones Industrial Index both made new highs in March while the Nasdaq Composite ended the quarter within 3.0% of its March 2000 peak. As of the end of March 2015, the S&P 500 and the Nasdaq posted gains for nine consecutive quarters. This hasn’t happened for the S&P since 1998 and has never occurred in the forty-three year history of the Nasdaq.
The flow of economic news during the first quarter of 2015 was mixed and somewhat hard to read at times. All in all, the incoming information was consistent with the “one step forward, one step back” theme of this last recovery. After a stellar 5.0% increase during the prior three months period, Real Gross Domestic Product increased at an annual rate of 2.2% in the fourth quarter of 2014, according to the third estimate released by the Bureau of Economic Analysis. But beneath the headlines, it remained apparent that the recovery was still chugging along at a slightly accelerated pace. For instance, inventory spending, which is infamously volatile, was responsible for almost all of the downward revision, while nonresidential investment was revised up, suggesting that the economy’s underlying strength, believe it or not, actually increased. Also, final sales to domestic purchasers grew to 2.9% annual growth, which is the best it’s been during the entire recovery, pointing to continued growth.
The manufacturing sector also provided mixed results. The Institute of Supply Managers’ Manufacturing Index slipped in March for the fifth consecutive month, reflecting the huge impact the fall in the price of oil has had on the energy sector and the significant negative role the rising value of the dollar plays in manufacturing exports. However, the Index remained above 50, which is a dividing line between expansion and contraction. Meanwhile, the Non-Manufacturing ISM Index, which represents the bulk of the economic activity in the nation, consistently showed strength, holding steadily at levels consistent with the recovery throughout the quarter.
The labor market looked fairly robust for the first two months of the quarter, averaging healthy growth of over 250,000 new jobs per month. In spite of the disappointing March jobs reports, initial jobless claims remained comparable with the lows of previous economic expansions, keeping unemployment at 5.5%, a level not seen since before the credit crisis. That strength, however, has not translated into healthy wage gains, which have grown at a relatively modest 2% year-over-year.
Personal spending was similarly unimpressive, and so were retail sales, although one should note that the retail sales data includes our spending on goods but not services. This is significant because spending on services makes up a much larger portion of consumer spending than spending on goods. With that in mind, while the spending on goods appears to have been stagnant in the first quarter, spending on services rose almost 5.0% during the same time period. Furthermore, readings of consumer confidence were strong, and with strong job creation and rising consumer confidence it is hard to imagine that consumption will not follow, especially in the U.S.
The Federal Reserve remained on the sidelines, keeping in place a zero interest policy implemented back in 2009. However, with the improving labor market and the domestic economy showing signs of sustainable growth, the Fed acknowledged that it no longer needs to remain “patient” when it comes to normalizing the target rate and is prepared to unwind its extraordinarily easy monetary policy. Of course, a very benign inflation environment provides the Fed with a comfortable degree of flexibility when it comes to the timing and the trajectory of interest rate hikes.
Back in 2009, when the world just began to dig its way out of the financial crisis, central banks were pumping substantial liquidity into the financial system in order to provide a jumpstart to a new wave of global economic growth; stocks were almost universally cheap and the opportunities were plentiful. In the atmosphere of the falling economies, falling markets and falling interest rates investors were able to buy stocks literally “with their eyes closed”.
Jumping ahead to today, the future direction of the stock market is much less clear. Various segments of the equity market are now at different stages of their respective market cycles, meaning that opportunities still exist but a more cautious approach is required in the current environment. The financial markets remain jittery, trying to sort through a number of factors – a rising dollar, high valuations, low yields and the pending start of a new rate hike.
We believe that although a strong dollar may depress corporate earnings expectations, it unquestionably has some positive long-term effect, boosting consumer spending and therefore supporting corporate profit growth. As for the start of the next rate hike cycle, while we anticipate some initial “knee-jerk” market reaction, it is important to understand that the Fed is not going to be raising rates to combat inflation, but rather to unwind an unprecedented monetary experiment. Therefore, the market should consider the Fed’s action as a reflection that the economy is strong enough and is no longer in need of an emergency zero-rates policy.
While no one will argue with the fact that current stocks’ valuations are not at the “bargain” level, they are far from being excessive. We see continued opportunities in equities, where earnings yields remain highly attractive relative to both U.S. Treasury bonds and inflation. Companies are continuing to take advantage of low corporate borrowing costs and high earnings yields. Merger-and-acquisition and share buyback activity remains robust, and this activity can provide a floor to the equity markets during periods of volatility.
Looking ahead, other than what we would consider “normal” corrections in the range of 5% to 10%, we see no apparent or imminent forces that could derail the market’s steady climb. We believe that conditions exist for the current six-year old bull market to further extend itself albeit with not quite as much strength as we have previously experienced.
Dumont & Blake Investment Advisors, LLC
March 31, 2015