Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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2014 Q4 Market Review: A Look Behind and Look Ahead

February 8th, 2015

We begin the new year by taking our regular quarterly temperature of the markets. As you know, we do not believe in making forecasts, but we also comment on what to watch for in 2015. As usual, our goal is to look at recent market results, put them in perspective, and see how that experience should set our expectations going forward.

This post looks at the following topics:

  • 2014 Q4 Markets Review
    • An Exceptional Year Ending in Volatility
    • Optimism Drove Stocks
  • A Sneak Peak at 2015
  • Bottom Line

An Exceptional Year Ending in Volatility

Market reviews are great for keeping us honest as we witness the twists and turns in economic news and market results. You may recall from our earlier newsletters that there were three major themes dominating headlines early in the year: emerging market jitters early in the quarter, Russia’s incursion into Ukraine, and a long and brutal winter that negatively impacted economic results at home. Then the market shrugged all this off and just kept chugging along until hitting a rough patch in October.

When you look at the returns which follow, it is worth recalling that many market forecasters believed that the market “had” to fall in 2014 following a great year for stocks in 2013 (neither year experienced even a 10% decline). However, the real surprise to many has been the strength of the bond market. And of course, nobody forecast the huge declines in energy prices. It all makes a great case for how unpredictable the future is, and why it pays to hold a diversified portfolio.

Overall observations for the fourth quarter and 2014 include:

  • The year ended on a crazy note, with lots of shifts in the markets in the fourth quarter:
    • Small caps surged after trailing the rest of the year.
    • REITs gained even more and had a tremendous year.
    • Long Treasury bonds (not shown) kept pace with REITs (both were up 25% and 30%, respectively for the year).
    • Commodities had a dreadful quarter and year, owing to a steep drop in the price of oil.
  • In all, it was a notable year, with 2014 being the sixth up year in the market, the third double digit advance, and the fourth longest post-war advance.
Market Returns
Market Index December Q4 2014 2014
Stocks        
Large Cap S&P 500 Index    -0.3% 4.9% 13.7%
Midcap S&P Midcap 0.8 6.4 9.8
Small Cap S&P Small Cap 2.9 9.9 5.8
Non-US Developed Markets MSCI EAFE -3.5 -3.6 -4.9
Emerging Markets MSCI Emerging Mkts. -4.6 -4.5 -2.2
US Bonds Barclays US Aggregate 0.1 1.8 6.0
REITs S&P US REIT 1.9 14.4 30.3
MLPs Alerian MLP -5.6 -12.3 4.8
Gold Dow Jones-UBS Gold Sub index Total Return 0.7 -2.3 -1.8
Commodities Dow Jones-UBS Commodity Index TR -7.1 -11.9 -18.8

Sources: AJO Partners, Factset, Dow Jones Indexes

Although not shown in the above table, a major influence on markets in recent months has been the US dollar’s surge in relation to other currencies. The Dollar Index, which is a weighted average of the currencies of the nation’s major trading partners, has risen to its highest level in over four years. For a discussion on how the rise in the dollar impacts stocks, please see our 3rd quarter market review at http://www.kuligfinancial.com/blog/.

Finally, few could have predicted the outright collapse in oil prices. We began the year near $100 per barrel and ended just north of $50 per barrel. When and where oil will stabilize is anyone’s guess, but the decline in crude is responsible for the 10% drop in the S&P Energy sector. It was the worst performing of the 10 industry groups that make up the S&P 500 Index.

Optimism Drove Stocks

Despite currency shifts and a major commodity collapse, the markets continued to move forward. Whatever came along, the fundamentals re-asserted themselves, driving stocks to new highs. These included:

  1. An acceleration in economic activity, which led a pickup in earnings growth. S&P 500 earnings improved from a modest increase of 5.6% in Q1 to a solid 10.3% by Q3, according to Thomson Reuters.
  2.  A pledge by the Fed to keep short-term interest rates at rock bottom levels for a “considerable time.” Without drowning you in the tedious details of discounted cash flows, low interest rates provide little in the way of formidable competition for stocks. Postscript: by now we know that the strength of the dollar and deflationary winds from Europe may also stay the Fed’s hand from rate increases.
  3.  Stock buybacks by corporations continue to rise. According to S&P Dow Jones Indices, combined dividend and buyback expenditures set a new record of $892.66 billion for the 12 months ended September 30, with stock repurchases representing 62% of the total. Stock buybacks reflect confidence as well as real demand for shares.

Jeremy Siegel, commentator and professor at the Wharton School of Business,  noted at year’s end, “The last three, four years, I thought this was easy. I mean, it was a slam dunk. The market was so undervalued with the interest rates so low, and earnings momentum going up. … Earnings momentum is going up, but we are closer to fair market value.”

Before we get carried away with unbridled enthusiasm, it’s fair to point out that Siegel was relatively bullish on stocks as part of a panel discussion that was published by Business Week in May 2000.

And it highlights why diversification between and among asset classes is always a good idea. No one has a crystal ball. No one can accurately foresee the unexpected events that may derail the most thoughtful forecasts.

A Sneak Peak at 2015

The fundamentals that have fueled equity gains in recent years remain in place. Even as the Fed ended its controversial bond-buying program last October, the fed funds rate is expected to remain at historically low levels through at least the end of 2015 and possibly beyond.

Moreover, the European Central Bank moved on its hints made all year by announcing it will start a quantitative easing program, as it battles a severe disinflationary environment. Simply put, central bank generosity has historically been a tailwind for stocks.

But let’s not get carried away. Let’s keep a balanced approach. Let’s adjust our portfolio when changes in your personal situation or goals make our current stance less than optimal.

While strong fundamentals remain in place, risks never disappear, even in a diversified portfolio. We can manage but not eliminate risk. So that leads to the next question – what may be some of the events that could create volatility in 2015. Here are some possibilities:

  • The year ended with oil near $50 per barrel, and it has since declined further. A recent story in Reuters noted $150 billion in energy projects around the globe face the axe. That means there will be winners and losers at current prices. Economists continue to debate whether the net gain to the US economy will be positive, since lower gas prices mean consumers have more money in their pockets.
  • Meanwhile, Russia is undergoing a wrenching adjustment, as its energy-dependent economy must adapt to the new reality. The Russian ruble has fallen sharply this year, and Russia’s central bank said its economy could shrink by as much as 4.7% in 2015 if oil averages $60 a barrel.
  • A 1998-like crisis that briefly walloped stocks doesn’t appear to be on the horizon, but any contagion that seeps out of Russia could create volatility at home.
  • Then there has been the steep selloff in junk bonds tied to the energy sector. While Treasury and investment grade yields fell last year, yields on junk bonds rose. Some of the rise can be blamed on expectations the Fed will eventually raise interest rates, which could crimp some highly-leveraged borrowers. But a big part of the increase can be blamed on default fears in the energy patch amid a re-pricing of risk in high-yield energy bonds. If concerns were to seep into other sectors of the junk bond market, we could see a spillover into stocks.
  • One test the market faces early this year: Greece is set to elect a new president in January (postscript: he did get elected), and there are worries the far left could take the top spot.
  •  While political leaders on the left favor staying in the euro-zone, they want to renegotiate the terms of the Greek bailout. Markets rarely enjoy grappling with an added layer of uncertainty.
  •  Slowing growth in China and Europe’s tepid recovery could dampen growth at home. Odds are fairly low, as the U.S. isn’t dependent on overseas demand to drive its economy. So far, U.S. growth has accelerated in the face of global jitters.
  •  Will we get volatility around the Fed’s first rate hike in nearly a decade? There are no guarantees when it comes to Fed policy, but if U.S. employment and economic growth continues at the current pace, the Fed has signaled rates will start rising in 2015. Although it is doing its best to telegraph its intentions, markets could get jittery in the interim. This one is a tough call, as some analysts also think the Fed will avoid increasing the strength of the dollar by raising rates. Deflationary pressures also may delay the Fed’s rate hike plans.
  •  Emerging market anxieties. A stronger dollar and a Federal Reserve that is expected to begin raising rates could pressure developing countries that have sold bonds in greenbacks instead of their local currencies, forcing them to repay loans in more expensive dollars. Foreign reserves (akin to a rainy day fund) could minimize any pressure, but it’s something that bears watching.
  • Liquidity is like oxygen to the market. A brief surge in U.S. Treasury prices and the steep but short-lived stocks selloff in October can be partly blamed on a temporary lack of liquidity. Some cite well-intentioned regulations put in place after the 2008 financial crisis.
  • Cyber-attacks. North Korea’s alleged attack on Sony quickly comes to mind. It’s impossible to forecast, but the outside chance of a big event can’t be completely discounted.
  • Geopolitical fears. War or geopolitical instability has historically caused short-term losses. Whether the Arab spring, Russia’s incursion into Ukraine, or the rise of ISIS (ISIL) in Iraq, heightened uncertainty is not a friend of investors.

Bottom Line

I always stress the importance of being comfortable with your portfolio. As we discuss in our meetings, my goal is to help you mitigate that risk. But you must be comfortable with the level of risk you’re taking as we set out to meet your objectives. If you are not, let’s talk and recalibrate.

Stick with your plan. Markets rise and markets fall, but unless there have been changes in your circumstances or you’ve hit milestones in your life, such as retirement, stay with the plan. By itself, a record high in stocks isn’t a good reason to bail out of stocks.

Rebalance. Last year’s rise in equities may have created imbalances in your portfolio, taking your target stock and bond allocations away from target weights. Now may be the time to take profits on winners and selectively re-allocate proceeds.

I hope you’ve found this review to be educational and helpful. If you have any questions or would like to discuss any matters, please feel free to give me a call.

As always, I’m honored and humbled that you have given me the opportunity to serve as your financial advisor.

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.