The final three months of 2014 followed a familiar pattern: U.S. stocks recorded substantial gains (the S&P 500 Index gained almost 5%; the small-cap Russell 2000 was up twice that), while most other investment categories lagged. Pockets of strength included Real Estate securities and Chinese stocks; most other non-U.S. equity markets, high-yield bonds and, especially, commodities turned in negative results. Treasury yields fell (again), with the 10-year Note finishing the period at 2.17%, down from 2.51% at the end of September; credit spreads mostly widened, however, holding most bond returns to around 1% or less on the quarter.

Within the U.S. market, the best performing stocks groups were Consumer Cyclicals, Consumer Staples, Financials and Utilities (the last being by far the strongest). Telecomm, Technology and (especially) Energy stocks lagged. As noted, small-company stocks turned in a very strong quarter, but this only partially reversed early-year underperformance. There was no clear performance distinction between growth- and value-oriented investment styles.


Benchmark Performance – Equities


Fourth Quarter 2014

Last Twelve Months

     S&P 500 Index



     Large-Cap. Core Mutual Fund Avg. (Morningstar)



     Small-Cap Stocks (Russell 2000)



     Non-U.S. Stocks (Developed – MSCI EAFE)



     Non-U.S. Stocks (Emerging – MSCI EM)




Benchmark Performance – Fixed Income

Fourth Quarter 2014

Last Twelve Months

   Barclays Intermediate Gov’t/Credit Index (taxable)



   Intermediate Municipal Mutual Fund Avg. (Morningstar)




Economic and financial-market developments of the past twelve months featured substantial continuity with those of 2013. The U.S. economy performed better than most; after an up-tick around the end of 2013, global bond yields continued to fall; the Federal Reserve proceeded on its slow, steady march toward ‘normalizing’ monetary policy; and U.S. financial markets handily outperformed nearly all others. Surprises there were, however. Few predicted the degree of Vladimir Putin’s audacity vis a vis Ukraine or the resulting deterioration in relations between Russia and the West. Likewise, the ascendancy of the Islamic State in the Middle East was on no one’s radar screen a year ago. And finally, the collapse in the price of oil – down more than 40% during the year – caught nearly all off guard.

In its fifth full year of recovery following the 2008-2009 financial crisis/recession, the American economy finally seemed to regain some of its swagger. Employment growth accelerated to nearly 250,000 net jobs per month – bringing the unemployment rate down to 5.8% from 7.0% at the end of 2013 – and purchasing-manager surveys indicated both manufacturing and service businesses were operating near the highest rates of the recovery. Meanwhile, the residential real estate market continued to rebound, albeit at a subdued pace compared with 2013; across the country, home prices were up around 5% on average. The combination of a better job market, rising house and stock prices, and plunging energy costs led to a sharp rise in consumer confidence. Finally, one statistic that has been notably sluggish during the recovery – wage growth – showed encouraging signs of acceleration as the year ended.

Outside the U.S., economic developments were disappointing. In Japan, a hike in the value-added tax had a much greater than expected impact on household spending, sending the economy into yet another recession, while observers continued to await promised structural reforms. Among emerging markets, Brazil seemed headed for recession while Russia was on the verge of a meltdown, and growth in many resource-dependent economies (e.g., Venezuela, Nigeria, South Africa) was handicapped by plunging commodity prices. Chinese policymakers continued their complicated task of reorienting the world’s second-largest economy toward a more consumption-based model while avoiding an abrupt slowdown. Though this process has so far been relatively incident-free, growth slowed sufficiently late in the year to prompt the loosening of financial policies that had been tightened during 2012-2013 in a largely successful effort to deflate an urban real-estate bubble. Perhaps the most troubling news came from continental Europe (the U.K. economy continued to fare relatively well). Despite diminishing fiscal austerity, growth flagged in the core of the euro zone, with several economies flirting with recession and inflation falling well below 1%. Particularly disturbing was a significant deceleration in Germany, the zone’s most important and heretofore strongest economy.

Weakness abroad largely offset a healthier U.S., with the result that global economic growth was probably only slightly better than 2013’s lackluster 3%, which was the slowest pace since the recession-year of 2009. Central bank policies remained extraordinarily accommodative in all major economies, while weak demand combined with falling commodity prices allowed inflation to continue its slide lower. In response to both low growth and falling inflation, government bond yields, too, continued to fall. At yearend, the 2.17% yield on 10-year U.S. Treasury notes was actually among the highest in the developed world: corresponding rates for other major markets were 1.95% in the U.K, 0.84% in France, 0.55% in Germany and 0.33% in Japan; stunningly, even Italian and Spanish sovereign yields were below those in the U.S, at 1.99% and 1.70%, respectively.


What’s Changed

A sluggish global economy seemingly posed no obstacle to profitability for large U.S.-based companies, however. The aggregate earnings of companies comprising the S&P 500 Index increased 10% in the quarter ended September 30th, bringing the trailing-twelve-month gain to 12%. Wall Street analysts project a similar gain (+12.3%) for 2015.

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1) Dividend Income (for three months this is the annual yield divided by four)

2)  +/- Change in Earnings per Share* (average for S&P 500 companies)

3) +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

  * based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to give us the +4.9% S&P 500 total return?

Fourth Quarter (October-December) 2014
Dividend Income +0.5% +4.9%
+ Change in Earnings +2.7%
+ Change in Valuation +1.7%
= Total Return +4.9%

Our read: For the full year, earnings grew almost exactly in-line with prices, leaving valuation essentially unchanged; we would like to see earnings grow faster than prices for a while to bring valuation down nearer its historical average.



The global economic recovery following the financial crisis of 2008-2009 has been persistently weaker than the historical norm, as households deleveraged, banks repaired balance sheets, governments implemented austerity policies, and businesses faced with uncertain growth prospects were reluctant to invest in new capacity. Though U.S. corporations and financial markets have, to date, coped surprisingly well with a slow-growth world, the trend is worrisome as deflation looms and unpleasant political developments could be exacerbated by persistent weakness. A key question for the period ahead, then, is whether a global growth acceleration is in store.

We expect the U.S. economy to do quite well in 2015, boosted by lower energy prices (which by most estimates will result in as much as $1,000 of incremental spending power for the average American household), continuing improvement in wage growth and perhaps even a return of long-absent ‘animal spirits’ in the business sector, leading to an uptick in investment. Overseas, while none of Europe, Japan or China seems poised for a growth explosion, there is nevertheless an argument for less-bad results in all of these regions. In Europe, the worst of fiscal austerity is in the past and the European Central Bank is likely to embark soon on a new stimulus effort via ‘quantitative easing’ (the creation of new money to purchase bonds). Meanwhile, Japan will not repeat the error of raising taxes, and recent elections give the Abe government a mandate to begin making long-overdue structural reforms (though these will take time to bear fruit). Chinese authorities only recently shifted back to a policy of stimulus via lower interest rates and easing bank regulation, which should begin to impact growth in coming months; Beijing’s strong fiscal position could allow stimulus on that front, too, should growth continue to disappoint. In addition, these economies are all resource importers that, like the U.S., will benefit from lower commodity prices. Finally, Japanese and European export industries will receive a boost from weak currencies.

Another development on the near horizon is a likely shift in the U.S. monetary-policy environment. Federal Reserve officials have spent much of the past 18 months preparing economic and financial-market decision makers for the prospect of tighter policy (i.e., higher interest rates). Policymakers have indicated that, given expected economic trends, the Fed anticipates beginning to raise short-term rates around the middle of 2015; market-based measures indicate investors think the interest-rate ‘lift off’ will come somewhat later in the year. We believe investors, on balance, fear too-aggressive tightening that might derail growth more than too-loose policy that could unleash a meaningful rise in inflation. And given the combination of still-high long-term un-/under-employment, on the one hand, and inflation persistently below the unofficial 2% target, on the other, we believe the Fed will prefer to err on the side of ease and keep short-term rates abnormally low for a long time once they begin to rise. In any case, prolonged preparation and the Fed’s keen desire to avoid miscommunication make a major surprise unlikely, in our opinion. Nevertheless, we would not be surprised to see an increase in volatility as the year unfolds, especially with yields meaningfully lower than a year ago.

Geopolitical uncertainty and associated risk are also on investors’ minds entering 2015. The collapse of commodity prices will pressure governments of resource-dependent economies, among which Russia is of greatest concern (Venezuela, Iran and Nigeria bear careful watching, too).  The combination of rapidly declining oil revenues and Western sanctions has pushed the Russian economy to the brink of crisis.  While this weakened position may cause President Putin to be more accommodating in his dealings with Kiev and the West, the opposite reaction cannot be entirely discounted.  A reemergence of political drama in the euro zone may also be in store.  Greek elections later this month are expected to return a left-wing government that may seek to renegotiate or repudiate the terms of past bailouts.  The risk of a ‘Grexit’ from the euro bloc infecting other economies via the bond market and banking system is probably lower than it was in 2011-2012. But we worry that persistent economic weakness across the Continent could fuel the rise of extreme parties like UKIP in Britain, France’s National Front and Alternative for Germany (recall that the economic misery of the 1930s, in the aftermath of the last global financial crisis, paved the way for some particularly loathsome European political movements). Finally, though a seemingly well-entrenched economic upturn should help dissipate tensions, we note with caution recent confrontations between police and urban minority communities across America, as well as the emergence of income/wealth inequality as a resonant political issue. Should the U.S. economy falter unexpectedly, such issues could lead to spreading calls for protectionist, anti-immigration, and soak-the-rich policies that would be detrimental to the interests of investors (perhaps narrowly defined).

As noted in the ‘What’s Changed?’ box above, earnings growth has kept pace with rising stock prices over the past 12 months, leaving valuation essentially unchanged: at yearend, the S&P 500 Index traded at approximately 17.5 times trailing earnings – some 10% to 15% above the historical average, but reasonably appropriate for a prolonged period of strong corporate profitability and extremely low interest rates.  We wrote in October of our concern that investor sentiment was beginning to get frothy; a brief but sharp market swoon in mid-October and subsequent price corrections among high-flying bio-tech stocks have, we think, gone some ways to alleviating this worry.  We eye somewhat suspiciously, however, the recent uptick in merger and acquisition activity. On balance we believe this represents a less-than-optimal use of scarce management resources – financial engineering in lieu of productive investment – and may also signal that a growing number of executives view their companies’ stocks as fully valued.

In closing, we repeat our observation that after nearly six years of rising prices the reward/risk trade-off on offer to investors in (especially U.S.) stocks surely has become less compelling than at earlier stages of the Bull Market.  And with yields meaningfully lower than a year ago, the bond market too seems to offer scant value.  Accordingly, we believe investors should temper their expectations regarding returns over the next several years in a low-growth, low-inflation, low-yield environment.  With valuations above average and capital appreciation relatively scarce, we believe it will become increasingly important to focus on relative value, which we believe may be found in select non-U.S. equity markets, as well as on investments in high-quality businesses capable of sustaining and growing dividend payments.  These are circumstances in which Oarsman Capital’s investment process, which combines a globally oriented macro approach with a proven, bottom-up system for identifying attractively priced stocks of great companies, is particularly suited to add value.

We welcome your comments and questions regarding our management of your investments, and wish you a healthy and prosperous New Year.

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