2015 1st Quarter Outlook

Review of last year

2014 was a good year for stocks – indeed the last five years have been a very good period to be an equity investor. The table below shows historical annualized returns:

U.S. large company stocks increased in value by 14%, mainly because of an improved outlook of the U.S. economy. There is little mystery of why stocks are at or near an all-time high – corporate earnings (the major factor influence stock values) are at an all-time high. Small company stocks did not do as well – they increased in value by 5%, and over the past 30 years, they have underperformed large company stocks. Developed market stocks and emerging market stocks declined by 5% and 2% respectively, reflecting lower growth rates abroad, and increasing economic and political risks. Bonds had a very good year – interest rates declined (defying more expectations) and corporate bonds were viewed more favorably because of the strengthening economy.

Economic Outlook

The current economic data is very positive. To summarize:

• The unemployment rate has been continuing its steady decline since the recession. It’s currently at 5.6% -- at this point last year it was near 7%.

• Real Gross Domestic Product (GDP) grew at an annual rate of 5% in the 3rd quarter, following a 4.6% growth rate in the second quarter.

• Core inflation has been well below 2% - a consistent level we have not seen in over 50 years. And that does not include the impact of lower energy prices

• Corporate profits are at an all-time high level, bolstered in part by greater corporate efficiency, measured by profit margins

• Individual and corporate debt ratios are low and continuing to decline, which means less financial stress and lower delinquency rates

• Lower prices of energy as a proportion of total consumption have continued to decline over the past 10 years. Part of the reason is the development of shale gas in the U.S., which has caused an economic boom in some regions and has led to relatively cheap prices for natural gas in the U.S.

• Consumer confidence (measured by the Consumer Sentiment Index by the University of Michigan) is at its highest level since 2007

Stock Market Outlook

The specific stock market data are also promising. Most of the reason why stock returns have been good in the recent past has been the improved economic picture. One interesting facet is the average earnings yield in the stock market (earnings divided by price) is actually significantly higher than the corporate bond yield – that had never occurred before 2009. And despite comments in the press, average volatility in the stock market over the past three years has been much lower than the long-term historical average. However, there are a few concerns about the U.S. stock market:

• Valuation – As we have frequently noted over the past few years, the price-to-earnings ratio for U.S. stocks has recently been below its historical average. However, it is currently slightly above its historical average. This means we would expect returns on stocks over the next several years to be much closer to the long-term average of 10% than the recent five-year average of 20%. It also means there is more likely to be some degree of increased volatility in the stock market.

• Interest rates – The Fed has announced that it will increase interest rates over the next few years. When those increases actually occur, there may be some adverse reactions.

• Energy uncertainty – Prior to 2008, lower energy prices have always been a boon to the economy and the stock market. However, since the financial crisis, the market has actually moved more in sync with energy prices. Part of the reason may be because of the potential political risk in countries that have economies that are highly dependent on energy exports (Russia, Venezuela, and several in the Middle East).

• Stuff Happens – This is always a concern; we don’t know what we don’t know. Most large market declines come from unforeseen events.

Bond Market

Over the past several years we have expressed our concern about the bond market. The good news is that last year we were wrong – it was a solid year for bonds. The bad news is we believe that increase is not supported by long-term factors, and over the next several years interest rates will increase. We recommend that investors diversify much of their portfolio away from Treasury bonds and indexed bond funds, and include other types of bonds such as investment grade corporate, high yield, and emerging market debt. We also recommend that they keep their bond investments in the short and intermediate sections of the yield curve, with average maturities less than six years.

Summary

To summarize, we have come through a strong year of economic improvement, and it has been a great five-year period for investing in stocks. We currently have a stable U.S. stock market, with average prices relative to earnings, and reasonable growth prospects. The situation in Europe, while more settled than several years ago, is more uncertain, and there is good potential for growth in emerging markets. Bonds, while providing desired stability and diversification attributes, will likely be providing modest returns in the future. While we believe there will be lower stock market returns in the future than we had in the recent past, we feel very comfortable recommending balanced portfolios including an appropriate portion of equities.

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