The roller-coaster ride of 2014 made for an odd year in many ways. It added one more notch to the current bull market, making it the second strongest annual winning streak in history. It differed from its predecessors in the way of low correlations of different market segments as mid and small capitalization stocks were declining when large caps were hovering near their highs – unlike the strong positive returns of all three in 2013. It started and ended on a negative note but brought strong overall gains, defying the old market perception that “promised” a poor year for stocks after the negative month of January 2014.
The perennial “Santa Claus” year-end rally, defined as the last ten trading sessions of December, delivered as expected. A number of domestic equity indexes reached new all-time highs. The S&P 500 Index ended the year up 13.7% posting over 50 record highs along the way. The Dow Jones Industrial Average managed to gain 10.0% while small and mid-size indexes gained only 5.0 %.
It was a rough year for international markets. The MSCI EAFE Index of the developed countries declined 7.4% for the year while the MSCI Emerging Markets Index lost 17.6%.
The fixed income markets held up surprisingly well in 2014. As the inevitable rate increase was put off for another year, the yield on the 10-year U.S. Treasury Note slipped to 2.2% by the end of December, and the Barclays Aggregate Bond Index finished the year with a 6.0% advance. Confounding virtually all analysts’ 2014 predictions, long-term 30-year Treasuries were stellar performers posting a gain of 27.3% for the year.
Our domestic economy ended the year on a high note, accelerating to its highest pace of growth in the past eleven years. Gross Domestic Product, which measures the value of all goods and services produced in the U.S., grew at a 5% annual rate in the third quarter of 2014, up from an initial estimate of 3.5%. This was the fastest rate of growth since the third quarter of 2003, stemming from stronger consumer spending and business investment.
The U.S. added 321,000 new jobs in November marking the biggest gain in nearly three years. The unprecedented 50-month uninterrupted job growth is now the longest in history. Virtually every industry added employees, and many of the new jobs were in higher paying fields, offering more evidence that the U.S. economy could be gearing up for its best year of growth since the end of the Great Recession. The nation’s unemployment rate, meanwhile, held steady at a six-year low of 5.8%. Forward-looking indicators suggest that the strong economic growth should continue. This view was further supported by the Federal Reserve, which raised their estimates for GDP for the coming year during its last meeting and reaffirmed its intentions to start raising interest rates in mid-2015 should the data support such an increase.
The steady and impressive rise of the stock market since the crash of 2008 has been one of the most doubted rallies in the history of Wall Street. Numerous record highs in major market indices generated no trace of the euphoria that surrounded the 10,000 mark of the Dow Jones back in 1999. The entire 245% appreciation in the S&P 500 since the March 2009 bottom has been met with unwavering investors’ skepticism and, even now, U.S. investors are sitting on $11 trillion dollars in cash earning zero. Frankly, we’ve never seen a market so hated by so many people for such a long period of time.
Valuations for the S&P 500 remain slightly above the long-term average, indicating a somewhat expensive market. Are they reaching the dangerous levels that precede a reversal of market trend? While we acknowledge the rise in valuation metrics, we do not expect the above-average valuations to lead to an end of the bull market. Valuations, in general, have a poor record of timing market tops, and their latest expansion has been about average for every bull market since 1957. Most importantly, the macro conditions, including the healthy growth of companies’ earnings, subdued inflation and the stronger dollar continue to support these slightly elevated valuations. Healthy earnings growth had been a primary driver of equity returns last year, and we expect this to continue into 2015. Simply stated, the growing economy justifies the positive market outlook.
Does the sudden drop in oil prices mean a sharp slowdown in growth is coming? We don’t think so. Quite the opposite, as airlines and manufacturers will benefit from cheaper fuel prices and U.S. consumers, who save about $1.4 billion for each 10 cent drop in gasoline prices, will get an addition to their discretionary income. So, if anything, lower oil prices may boost the GDP, not knock it down. As for the energy boom in the U.S., lower prices may slow down any capital investment in the sector but will not stop it. Furthermore, we believe our economy will continue to prosper despite the geopolitical headwinds and struggle in Europe and Asia. U.S. consumers paid down debt after the financial crisis and are ready to spend again, albeit cautiously. We are seeing a resurgence in manufacturing facilities as lower energy prices at home and higher wages abroad are having more companies open U.S. plants. Domestic companies too, are gaining market share all around the world, proving once again that the American economy, while not the largest in the world as of late, is still, by far, the strongest. We believe these trends will continue to support higher stock prices.
Many talking heads attribute – and somewhat rightfully so – the extent of the current bull market to the extremely accommodative policy of the Federal Reserve. Some even suggest that the Fed created a bubble, which will eventually burst, like the tech or the housing bubble in 2000 and 2007. Certainly, easy access to cheap funds and unprecedented low interest rates contributed to market performance, but we have yet to see the public choosing a single area of the market and chaotically throwing money at it, which essentially defines a bubble. Yes, the market may have gotten a little ahead of itself, but it is wiser to enjoy the momentum than to fight it. Will the end of the Federal Reserve’s accommodative policy change the momentum and end the bull market? It is unlikely that the Fed is going to derail the market next year. During the nine economic expansions over the past 50 years, stocks have subsequently performed well when the Fed started to hike rates in response to better growth, as the first rate hike usually comes only about half way through the economic cycle and well before the bull markets have ended.
The first few days of every year bring an increased number of pundits offering their forecasts for the future move of the market. We have our thoughts for the market for 2015 and while they are not predictions, they are educated expectations. Predicting the movements in the stock market is not an exact science nor do they follow any mathematical rules. The most important fiduciary duty of an investment advisor is not to impress the clients with the most accurate forecast, but to successfully steer their portfolio through the peaks and valleys of the market. Because of the market’s sometimes unpredictable nature, we believe that through diversification we can navigate the markets’ fluctuations efficiently and with less negative impact. On the other hand, diversification by definition means owning temporary laggards that we expect to be winners in the future. The key is to hold stocks across the size spectrum and in all regions, since no one can be certain when a reversal in the market’s “favoritism” may occur.
We are now entering the third year of the four-year presidential cycle which historically has been the strongest of all. While we prefer not to look in the rear-view mirror and don’t put a lot of the weight in historic precedents, all the available evidence leads us to expect the market to achieve respectable returns in line with their historic average for 2015.
Dumont & Blake Investment Advisors, LLC
December 31, 2014