Posted by David Tillson 2014 Fourth Quarter Commentary 

2014 ended on a note of strong economic growth, above average returns for the stock market, very low mortgage rates and gasoline prices, and an improving labor market. While the momentum from these factors should continue into the coming quarters, some surprise always seems to appear which upsets the best laid plans and projections. Nevertheless, as we move through 2015, we expect the following:

The stock market closed the year with a very strong fourth quarter which reflected both an improving economy and investors’ hopes that 2015 would be even better than 2014. With the S&P 500 Index adding another 13.7% to the robust performance of 2012 and 2013, those investors who remained fully invested have seen their assets rise by 75% over just these last three years. This is a phenomenal return considering that it has been accomplished in a 1.5% inflation and essentially zero short-term interest rate environment. While this period has been punctuated by brief, sharp market declines, the various worries coalesced and then quickly dispersed, leaving the impression of a constantly rising market. The sharpest decline occurred in April-May, 2012, when the S&P 500 declined nearly 9% before returning to setting new highs. Since then, the declines have been in the 4%- 6% range and have lasted only a few weeks, thus allowing the market to set new highs every month or so since February 2013. As can be seen in the chart, this pattern is not uncommon, but at some point we should expect to wait a little longer than 4 to 6 weeks for a new high. 


The four cornerstones of our investment philosophy are Fundamental Research, a Disciplined Approach, Common Sense and Patience. We spend most of our efforts on researching companies and build our portfolios by selecting stocks which have the best return potential. While we are acutely aware of the geopolitical and macro-economic environments and have strong views of how situations may play out, this is only one input into our analysis of how specific stocks may be able to perform in the future. One danger of making stock specific decisions using these macro events is made clear by Rudy Dornbusch’s (MIT professor who co-authored the textbook Macroeconomics) quote in a recent Barron’s: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.” The tech and housing bubbles were great examples of things that logically would happen but took years to unfold. During the build-up to these bubbles, many investors wondered how companies with no earnings could go public with astronomical valuations and how people with no income could get a mortgage for 100% of the purchase price of a house. In hindsight, these were not normal, but when that realization finally became clear, it happened very quickly, and those investors who thought that they had time to sell found that they were too late. 

The geopolitical and macro-economic factors which concern us at the moment include central banks’ quantitative easing (QE) programs, the collapse of oil prices, the Fed’s impending decision to raise interest rates and the specter of deflation. While these issues are unsettling, we remain very positive on the U.S. economy and cautiously optimistic for the rest of the world. As Dornbusch realized, these “things” are taking longer to play out than many would hope and it is likely that when they do happen, it will be fast and probably disruptive. The Fed’s bond buying program ended last October and depending on economic growth and the state of the labor market, their intention is to begin raising short term rates in June. However, the European Union has just embarked on an open-ended easing program as they try to pull themselves out of deflation and recession. Japan is in the middle of their program trying to do likewise. One of the consequences of these QE efforts is that the Euro and Yen are weakening against the dollar. If we Americans are planning to vacation in Europe or Japan, it is a great time to go; if we are trying to export to them, our goods are more costly. Imports into the U.S. however are much cheaper which is good for the consumer, but by importing deflation, we are making the Fed’s job of hitting a 2% inflation target more difficult. The main goal of any QE program is to force investments into riskier assets (generally the stock market) in order to increase economic growth and inflation. A weaker currency aids exporting, but if every country tries to weaken their currency to maintain their competitive advantage, it will be a race to the bottom fueling worldwide deflation. With the exception of Japan, most of the world does not have much recent experience with deflation. It was much more common in the 1800’s, but after the 1930’s (at least in the U.S.), inflation was the thing to worry about. Once ingrained into a society, deflation is terribly difficult to remove as consumers shift from a “buynow” to a “wait-for-the-sale” mentality. 

Although this may sound quite worrisome, we must keep in mind that governments continue to have powerful war chests behind them. The last six years since the Great Recession has been a period of muted recovery, but it has also been a period where investors have reset their expectations. Most no longer believe in “trees growing to the sky” but unfortunately, many became leery of even believing that they could grow to a normal height! As readers of our commentaries know, we believe that past is prologue – not that it will necessarily repeat, but more as Shakespeare suggested in The Tempest: that all that happens before leads to what will happen in the future. For us, understanding how markets and investors have behaved in the past gives us confidence to project how current events may turn out, but as Dornbusch pointed out, we still don’t know when.

The collapse in oil prices and the decline in bond yields in 2014 surprised the vast majority of forecasters and will profoundly impact economies and financial markets. Lower interest rates, declining inflation and cheaper oil are net positives for the U.S. economy as we enter 2015, but these same forces are contributing to rising economic and geopolitical strains abroad. As we look forward, we expect interest rates to remain low for an extended period of time, although the pressure for central banks globally to raise rates will intensify. As can be seen in the left hand chart, interest rates are now slightly below levels experienced for a decade after World War II. The chart to the right shows that changes in longer term rates have been very gradual, averaging only 2-3% every ten years – the exception being the inflation spike around 1980. Our scenario for the future is: 1) the Fed will begin to raise short term rates by mid year; 2) longer term rates may not necessarily rise concurrently with the Fed’s action and 3) longer term rate rises eventually will follow this 2-3% per decade pattern seen in the 1945 – 1978 period. 


The rise in longer term rates will depend on overall inflation expectations (wage inflation in particular) and the strength of the economy. Aiding in this battle to grow the economy and raise inflation is the fact that the Federal deficit has been declining for several years, government employment and spending are both now growing after more than four years of decline, and 23 states are set to increase the minimum wage in 2015. Whether a larger government is a good thing can be debated, but in the short term, it will be a positive, and a higher minimum wage will put more money in some workers pockets which should translate to more consumer spending and less government aid to those minimum wage workers. 

2014 ended on a note of strong economic growth, above average returns for the stock market, very low mortgage rates and gasoline prices, and an improving labor market. While the momentum from these factors should continue into the coming quarters, some surprise always seems to appear which upsets the best laid plans and projections. Nevertheless, as we move through 2015, we expect the following:

   1) the U.S. economy will continue to grow (no recession)                                                                2) oil prices will stabilize in the first quarter and recover somewhat by the 4th quarter                        3) the Fed will begin to raise interest rates in the third quarter rather than in June                              4) stock market returns will be in the 10% to 15% range, comparable to 2014                                  5) talk of deflation will wane as the Fed reaches its 2% inflation target by the end of the year