Looking back to the beginning of 2014, we expected markets to perform well. However, we cautioned that we shouldn’t expect returns as strong as were seen in 2013, which saw the S&P 500 advance 32 percent. Diversified investment portfolios didn’t perform nearly as well as a concentrated investment in large company U.S. stocks (S&P 500). When this occurs, we remind investors that allocation is the key to long-term success with investing. Not all asset classes advance (or decline) in lockstep. This is never more important than when we experience large sell-offs like we saw in 2007 and 2008. Our experience with market cycles provides us the ability to have patience and stick with long-standing risk management principles.
We suggested that U.S. large company stocks would provide good returns, small company stocks would cool and bonds would underperform. We were right on those three fronts. We were incorrect in our belief that developed international markets would outperform the U.S. markets. In fact, both developed international and emerging markets underperformed U.S. stocks by a fairly wide margin. Commodities were also weak as we saw prices in most all commodities weaken with interest rates and the U.S dollar strengthened. Our early thinking was that commodities would benefit from an eventual rise in inflation expectations. While this didn’t materialize, we still believe that we will eventually see inflation as a headline news story.
We predicted that interest rates would remain low but begin trending higher. Once again we were mistaken, the unprecedented low levels in US Government bond rates taking us by surprise. Each time rates begin to rise—as one would expect in a recovering economy—there seems to be an outlier event that creates fear and anxiety amongst investors the world over. Issues like Russia invading Ukraine, ISIS terrorist threats, Ebola outbreaks and OPEC decisions on oil production can cause a lot of short-term panic in the markets. When investors panic, they move their investments to safe haven assets such as US Treasury bonds, and this large demand for bonds pushes prices higher and rates lower.
We did correctly warn that a correction of seven to ten percent was very likely this year. From mid- September to mid-October, the U.S. markets pulled back almost exactly ten percent and at that time we advised clients to increase exposure to equities. Also, our suggestion to avoid gold in 2014 was important. Gold was the trendy asset back in 2011 and 2012 due to the fear pushers on TV and radio. From its peak in 2013, gold has fallen some 45 percent in value. Finally, we predicted that Republicans would take control of Senate and increase their numbers in the House. This came to pass as well, so we will see how policy is impacted in 2015.
Speaking of 2015, let’s discuss the primary themes we anticipate.
First, once again we expect a positive year for U.S. equities. Our economy is still in recovery mode and jobs have become more plentiful as businesses ramp up production, expand into new markets and start-up companies make a push for entry. We continue to favor large company growth stocks such as technology and healthcare, but we also currently see value in energy stocks, as they have been under significant pressure with the drop in Brent crude oil from a price of $102 to about $55.
We stay with our recommendation to overweight developed international stocks, as they are now trading substantially cheaper than their U.S. counterparts on a P/E basis. If the European Central Bank stimulates the Union with quantitative easing as the Federal Reserve did here at home, we expect markets to advance by double digits. Mario Draghi has already commented that he will do whatever it takes to promote growth. By using U.S. policy as a template, Draghi should find plenty of statistical support for such actions. Japan is also favorable in our view, as Prime Minister Abe is pushing for change in policy to be much more pro-business.
We are growing more and more concerned about bond prices with each passing month. At some point, interest rates have to adjust, and that could be soon since Fed officials are expected to begin raising rates in the first half of 2015. Remember, market rates change long before the actual Fed rate change is announced. Once rates begin their increase, we expect bond prices to come down rather quickly. As rates go higher and bond prices go lower, bond investors will realize that they can actually lose value in their bond holdings. Many of these newly shocked investors will decide to sell their bonds, which will likely create a domino of more selling and cause those inflated bond prices to correct even more. We suggest owning short duration bonds and prefer municipal bonds over government or corporates.
Volatility in energy prices could cause some issues for many smaller companies trying to obtain adequate capital. This could also create political instability in oil-producing countries. Our position is to stay with large, well-managed energy companies that have a history of dividend growth. We also believe that the keystone pipeline has a 75 percent chance of being approved with the Republican-led Congress taking over in 2015. This could mean thousands of new jobs and positive earnings for some of the Canadian pipeline companies and infrastructure companies that will be involved in building the pipeline.
So overall, we expect investors to do well by remaining overweight equities, both U.S. and International.
Now here are a few interesting facts to ponder:
* An average high-income American couple that retired in 2010 will pay approximately $765,000 of lifetime Social Security taxes but receive just $693,000 of Social Security benefits. (Source: Urban Institute)
* The Unites States is expected to require an additional 51,880 primary care physicians by the year 2025, over and above the number practicing today. The additional doctors are needed due to a growing, aging population and the effects of the Affordable Care Act. (Source: Robert Graham Center)
* Only 18 senators (out of 100) and 88 House of Representatives (out of 435) served in the military. In 1978, 77% of the members of Congress were military veterans. (Source: Vital Statistics on Congress)
*The national debt was $7.379 trillion as of 9/30/04. The debt today (as of 9/30/14) stands at $17.824 trillion, a $10.445 trillion increase over the last ten fiscal years. (Source: Treasury Department)