2014 4th Quarter Commentary

This has been quite an eventful year, both internationally and domestically.  Internationally we have seen increasing unrest in Hong Kong, Russian military antagonism, Middle Eastern unrest and an African pandemic that threatened the world. Domestically we had a significant shift in the political climate with a Republican takeover of the Senate. The more things change, the more they stay the same.

GDP surged to finish the year and we saw real improvement in the jobs market. According to the Wall Street Journal, employers added 2.7 million jobs in 2014 and we are set to post the best year of hiring since 1999. Job openings are running near a 13-year high. The unemployment rate has fallen to 5.8% from 7.0% a year ago. GDP growth has exceeded 3% in four of the last five quarters.  In two of those quarters, growth was in excess of 4%. Additionally, auto sales are reaching a level not seen since 2001.

As usual, it is not all clear skies ahead. Economic prospects are dimming across Europe, Japan and major emerging markets such as Brazil, Russia, and India.  This presents challenges to our more robust economy. Beginning in the middle of the summer, there has been a precipitous decline in oil prices.  OPEC made a decision, whether politically driven or in a desire to maintain market share, to keep oil production high in a period where demand has been weakening. The price of oil has been cut in half since July, going from $110/barrel to $50/barrel.  The effects have been felt across the globe in countries dependent on oil revenues.  Russia has suffered tremendously as the ruble has fallen 60% relative to the dollar. While the Ukraine-related sanctions have not helped the situation, oil is the main culprit.  All but two of the OPEC member countries require oil prices to be above $90 to balance their social spending and today’s prices are not sustainable.  Additionally, Venezuela, Nigeria and Norway are all suffering at current prices.  The U.S. is an oil-consuming nation relative to others that are net exporters, so low prices should benefit our economy.  That said, a measurable portion of the economic growth we have seen since 2009 has been related to the development of oil and gas fields in Texas and North Dakota.  Low gasoline prices are great, but if we start to lose oil-related jobs and capital investment, we fear the two will not balance each other out.

Once again we find Greece in the headlines with a recent election failure and a suspension of the bailout orchestrated by the IMF, EU and the ECB.  Until a new government is formed this bailout will be on hold and a “Grexit” (Greece leaving the EU) will be hotly debated.  The real impact on investors is what the EU and ECB decide to do at this point.  Germany has been cool to the idea of additional stimulus. Without stimulus and with Germany’s largest trading partner (Russia) on the brink, a European recovery (or at least enough growth to keep the EU out of recession) is in question.

Below is our list of worries that we continue to watch going into 2015:

  • Instability in Russia and the threat of more aggressive military action from Putin
  • Slowing growth in China and ongoing fears of Chinese banks with questionable loans
  • Growth of terrorist groups in the Middle East
  • Recession in Europe
  • The impact of falling oil prices on OPEC and other oil producing countries in the world
  • The threat of “hackers” who seek to control multinational companies through threats and blackmail

Stocks continued their march higher during the fourth quarter.  The S&P 500 returned 4.9% for the quarter and finished the year up 13.7%.  Mid-cap and small-cap stocks returned 9.7% and 5.7%, respectively, for 2014.  The developed international market actually fell over 4%, and the emerging international market fell over 2%.  This tells us that investors clearly favored large-cap U.S. companies.  We attribute much of this to the 5-year U.S. bull market, along with the potential recession in Europe and the contagion due to falling oil prices in commodity sensitive countries.  As a result of this divergence, the average domestic stock fund in the U.S. returned 7.4%, on average, for the calendar year.  (Source: Lipper)

The broad market has now posted gains in eight straight quarters, the longest winning streak in 16 years. Based on historical measures the overall large-cap market, as measured by the S&P 500, is not necessarily overvalued, especially considering low interest rates and other investment alternatives.  However, since the market bottomed in March 2009, the multiple that investors are willing to pay for future earnings has increased faster than earnings growth.  Forward P/E This also may have contributed to the outperformance of the S&P 500 versus other equity sectors, as valuations in the mid-cap and small-cap space are north of 20 times earnings, versus 17 times for large-caps.

In the fourth quarter, seven of the ten economic sectors posted positive returns. The two largest detractors were Energy & Telecommunications.  The Energy sector was down 10.7% in Q4, after falling nearly 9.0% in Q3.    In addition, at a Thanksgiving Day meeting in Vienna, OPEC members decided against reducing oil supply output, as previously mentioned.  This decision created further uncertainty in the energy marketplace, leading to additional declines in the price of oil and related equities.  The Telecommunications sector was down 4.2% during the quarter after smaller mobile phone companies tried to gain market share by lowering pricing, though still offering an inferior overall service.  We are currently finding value in certain companies in both of these sectors.

Utilities & Healthcare were two of the best performing sectors during the quarter and also posted the largest gains for the year.  For the quarter these sectors were up 13.2% & 7.5%, and for the full year were up 29.0% & 25.3% respectively.  USA TodayHealthcare stocks are benefiting from new drug discoveries and ongoing M&A activity.  Utilities continued to benefit from a low interest rate environment as they are typically regarded as “bond proxies” offering above average dividend yields.  But, Utilities as a group are trading at lofty valuations as seen the chart above.

Outside the U.S., equity markets in general have not fared as well.  Though the overall equity market has had a substantial advance over the last eight quarters, we continue to seek out and find value in individual companies in sectors and countries that have recently underperformed.  We do not know what the overall equity market has in store for 2015, but we continue to focus on a “bottom up” valuation approach, purchasing durable businesses at the right price, which has served us well over the years.

Prognosticators were largely proven wrong in 2014 regarding the fixed income market..  Bonds across the yield curve, taxable and tax-free, sold off in the second half of 2013 due to concerns over the end of Quantitative Easing.  Quantitative Easing came and went, and bond yields have fallen rather dramatically ever since.  The 10-year U.S. Treasury began 2014 at 3.0%, and ended the year at 2.2%, for a total return of 10.7%.  Global growth concerns, primarily in the Eurozone, drove a fair amount of “flight to quality.”  Interest rates in Euro denominated sovereign debt are materially lower than the U.S., so there is relative value in the Treasury market from a global perspective.  We believe the collapse in oil prices and its impact on economic growth has become a primary concern and is pushing yields lower.  Oil prices and headline inflation are positively correlated. Therefore, the drop in oil prices may result in negative CPI readings as lower input costs work their way through the economy.  We believe the Federal Reserve is monitoring these developments and a delay in the increase in the fed funds rate, largely expected by mid-2015, is likely the longer oil stays depressed.

Longer maturity bonds performed much better than their shorter counterparts.  The year to date return for 2-year U.S. Treasuries was a paltry 0.7% versus a robust 29.4% return for 30-year bonds.  The broad market, as measured by the Barclays U.S. Aggregate index, returned 5.9% for 2014.  It appears that bond investors are less convinced that the economy is strong enough to handle an increase in the fed funds rate.  Evidence of this can be seen in the flattening of the yield curve.  If the Fed raises rates too soon and/or too fast, the economy could tip into a recession, therefore making longer term bonds more attractive.  It is too early to tell if the incoming data supports a rate hike, but long term bond investors are clearly voicing an opinion.  This issue also proves that trying to time the bond market and rates is a dangerous game and having a strategy for staying invested with manageable duration risk key to meeting long term investment objectives.

It is worth noting that the high yield market did experience a correction at year end.  Investment grade and high-yield corporate bonds became cheaper as economic prospects became uncertain.  While we have avoided adding to this sector for a number of years, should yields continue to correct we will reassess.  The iShares High Yield ETF reached a high in June of 2014 of $95.43, only to close the year at $89.60.  This represents a yield of about 5.5%.  Currently we do not view this as an attractive risk/reward tradeoff but we are watching the corporate sector in general should this trend continue.

Municipal bonds were one of the top performers in fixed income for the year.  On a national basis municipal bonds returned around 9% for 2014.  Municipal budgets in many states continue to improve.  The risk on the horizon is the increased disclosure of pension benefits and its funding status, as well as “other benefits” that are granted to retirees such as lifetime healthcare benefits.  While we monitor these characteristics where available and factor this in the buying decision, it appears the municipal market has overlooked how dramatic these underfunded ratios can be under various assumptions. When these disclosures become public we could see some divergence in state municipal performance.

On the taxable side we continue to invest in step-up agency callable bonds, primarily at a discount.  While these discounts have shrunk with the rally in 2014, value can still be found.  We have been diversifying the agency offerings with taxable municipal bonds in lieu of corporates for several quarters now.  While this will continue at current spreads, should the corporate sector begin to show reasonable yields we will add them to our portfolios.

Our tax free strategy remains centered on investing in above market coupons in the 2025-2031 final maturity space with call dates from 2019-2023.  Yield levels shorter than that are under 1% and offer very little value.  In this structure we are finding high quality issuers trading north of 100% of U.S Treasuries.

Like most every other year, we begin the year hopeful that financial markets will navigate through the various storms that always seem to appear and uneasy about the unknown. Given what we know now, we do not see any reason to dramatically alter our exposure to stocks or bonds. We will continue to forage for underpriced companies. As we have noted in prior letters, it is all too easy to narrow our focus on whatever is most prominent in the news whether that be wars, recession or political unrest.  However, we have found a healthy dose of rational optimism is the best approach and has yielded good results. This is the path we continue to walk.