2014 Year in Review – Commentary

4Q 2014 Commentary: The Year In Review

by Richard Siegel, CFP®

There was no shortage of major financial and political news stories in the United States during 2014. Most notably the U.S. stock market completely decoupled from most global equity markets, continuing its impressive bull market run. Oil prices plummeted to levels not seen in over five years, mid-term election results shifted some power back to the GOP, and the continued escalation of terrorism and Russian aggression along with the Ebola virus has kept the world on high alert.

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After 5½ years of strong performance, the U.S. stock market is now one of the most expensive equity markets in the world. The chart above illustrates the high correlation the U.S. stock market had to the strengthening dollar beginning in August and the exact opposite effect on the foreign equity markets. Lower oil prices, surprisingly strong GDP, and job growth are reasons why stock prices should continue to climb. However valuations are moving into ranges that we are paying close attention to. With the exception of the energy sector, lower oil prices are a boost to corporate profitability. Additionally, consumers greatly benefit from lower prices at the pump with more money to spend and save.

Based on improving economic conditions, the Fed will most likely raise interest rates in the coming year. During the most recent Fed meeting, chairman Yellen removed the words “considerable time” when referring to leaving short-term rates at such low levels. The days of 0% interest rates will soon be behind us and CDs, savings accounts, and money markets will begin paying interest to investors once again, albeit at yields that will fail to impress for some time to come.

Geopolitics and other disruptive news should be viewed as short-term noise to long-term investors with diversified portfolios. Although volatility can be an issue during times of fear and uncertainty, investors should focus on their goals and attempt to keep their emotions in check. Instead, we focus on things we can control like a durable portfolio strategy, broad diversification to lower risk, and tax-efficiency.

Equity Overview:

Although there were periods of significant volatility in the equity market this year, rebounds were swift and decisive. The “buy the dip” mentality remained intact as bargain hunters deployed cash at every opportunity.  Overall, 2014 was another good year for the U.S stock market. The big winner was the S&P 500 Index returning 11.39%, the Dow Jones Industrial Average turned in 7.52% while the U.S. Mid/Small Caps as measured by the Russell 2000 Index brought up the rear with a return of 5.03%.

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Overseas, markets did not fair nearly as well. Many European and Asian markets are still recovering from the Great Recession, and have not enjoyed the same economic and corporate profits growth as we have domestically. Many of these countries are in the beginning stages of stimulative measures, whereas the U.S. has been aggressively supporting the domestic economy for several years. Going forward, the U.S. will be trending toward a tightening phase, while many foreign markets will be easing. It is our contention that foreign markets are setting up for significant outperformance based on valuations as well as monetary policy dynamics.

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Although the PE ratio of the S&P 500 is slightly above its historical average, low inflation, low interest rates, and respectable corporate earnings growth support stock prices at these levels. It is worthy to note that PE ratios were more than twice as high during the Tech Bubble as they are today. We remain convinced that as a broad asset class, equities continue to be more attractive than cash and bonds on a relative basis.

Fixed Income Overview:

At the beginning of 2014, the general consensus was that interest rates would continue rising from their historical lows of under 1.5% back in mid 2012. The benchmark 10-year Treasury began 2014 at 3.0%. It currently sits at 2.12%, which means that bond prices rose over the past year. Industry-wide, bonds represent the surprise asset class for 2014.

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It is counterintuitive to think that rates would drop in the midst of an improving economy. Therefore, it stands to reason that strong demand for U.S. debt had the effect of  pushing rates lower. Even though rates remain historically low, 2.12% is attractive versus the government debt issued from Japan at .31% and Germany at .54%.

Based on the very strong rise in the dollar versus other major currencies, foreign bonds generally struggled during the latter half of the year.

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Going forward, fixed income securities remain an integral component of our asset allocation strategies for income, diversification, and stability of principal relative to equities. Our models have taken into consideration that the return potential for government issued bonds is relatively low based on the current interest rate environment. Our methodology incorporates bonds of varying maturities, credit quality, geographic region, and a hedge against rising interest rates.

 We have recently made some significant enhancements to our portfolio strategies. Specifically, we added exposure to commercial real estate in order to capitalize on the strengthening U.S. economy. We have also placed greater emphasis on securities with low cash exposure, greater tax-efficiency, and lower internal operating costs.

We thank you for a great 2014, and look forward to working with you in future years to come.