I hope this article finds you happy and healthy. When looking back at the fourth quarter of 2014 we witnessed the stock market pull back by as much as 9% early in the period primarily due to global growth concerns. As mentioned in my prior blog post, this presented a buying opportunity to increase stock exposure in anticipation of new highs in the market. This played out well, as the S&P 500 finished the year near all-time highs at 2,058. So far this year the markets have experienced increased levels of volatility. These fluctuations are attributed to international politics, a strong US dollar, the wild ride in oil prices, and Europe and China slowdown worries. Knowing the economy is still growing and benefiting from lower oil prices and an accommodative Federal Reserve, we remain bullish especially within our favorite stocks and sectors.
Looking at 2015, we are seeing global economic divergence. More specifically, we will see the United States contract money supply by slowly increasing interest rates starting later this year. Meanwhile, the economies of Europe, Japan, and China will continue expansionary measures in order to promote further growth. The most pronounced impact of these expectations thus far has been seen in US dollar strength (time to go on that European vacation!), which puts stress on commodity producers worldwide and adds incentive for global investors to move money into the US. These rock bottom expectations for many global economies may provide pockets of value for investors.
An equally important theme for 2015 is increased volatility in the markets. This ever present component of investing can be seen as a blessing or a curse. We see volatility as opportunity to buy quality companies at lower prices, trade market ranges, and increase income through hedging strategies. While we have certainly seen our share of event-driven market fluctuations over the past few years, volatility as a whole has been largely subdued since mid-2012. By removing quantitative easing in late 2014 and discussing a pending interest rate increase in mid-to-late 2015, we expect more ups and downs as markets adjust to less accommodative US monetary conditions.
We would be remiss not to go more in depth on the biggest storyline of the fourth quarter, the collapse of oil prices. This phenomenon of a greater than 50% drop in oil prices since June 2014 has occurred primarily due to increased oil supply in the markets due to larger than expected production from the United States, Libya, and Saudi Arabia. The Organization of the Petroleum Exporting Countries OPEC, despite lobbying amongst the 12-member cartel, has maintained production levels as a means to defend market share against US shale and other competing sources. As such, there appears to be no near-term catalyst for increased fuel pricing and energy prices should remain in a range. Over the next 12 months, we would expect high cost producers to come offline, thus allowing prices to appreciate, but many of these companies have oil price hedges in place to keep them sustainable for the meantime. The winners of reduced fuel expenditures are the largest fuel importers, such as US, China, Japan, India, Korea, and Germany. The losers, on the other hand, are Russia, Venezuela, Nigeria, and Iran. While this does harm to US energy companies that are reliant on prices above certain thresholds ($50 for Bakken and Eagle Ford shale producers and $80+ for more unconventional deep water drillers), the GDP disruptions due to decreased capital expenditures and increased layoffs will be more than offset by the discretionary spending benefits to consumers.
The US has proved to be the strongest major economy and the stock market has compensated investors with significant returns and relative stability during the recovery. For individuals, 2014 provided another year of rising household wealth, high consumer confidence, reduced household debt levels, and falling energy costs. This should aid consumer spending with additional discretionary income. Corporations, after cleaning up balance sheets over the past few years, should continue to increase capital expenditures in the areas of technology and equipment. Similarly, the government has recently proposed a 7% expansion of the budget, which is necessary to upgrade old transportation infrastructure that is currently at post-WWII record ages. A total of 2.86 million jobs were created in 2014, the largest figure since 1997, and the unemployment rate declined to 5.6% in December the lowest since June of 2008.
We are also watching to see when the Federal Reserve will hike rates for the first time since 2006. Inflation remains under control with the personal consumption expenditure (PCE) currently at 1.2%, with a core reading of 1.4%. Given the fact that the Federal Reserve set its inflation target at 2.0%, the central bank continues to remain monetarily accommodative. Many believe this will change during the middle of 2015, but we expect this to first occur in late-2015 to early-2016. While the first hike will not be a game changer, the anticipation and implementation will be a volatility event. Historically, stocks tend to rally into an initial rate hike, and then flatten out upon the preliminary increase for roughly six months before resuming upward momentum.
Active management will remain an important component of our investment philosophy, especially with an aging bull market that is more demanding on the selection of which stocks and sectors have the best opportunities to increase. Earnings will drive performance in stocks, and so far the majority of earnings have outperformed for the fourth quarter. We are using our 40 years of experience to identify the right stocks and sectors, and to dictate the timing of our investments. We will be increasing our cautiousness on segments of the market that are most affected when interest rates rise. Investors should expect stock market pullbacks and heightened volatility at times, but these events create buying opportunities for long-term investors. All in all, the markets may not march upward in a straight line, but will continue to do well in 2015.