Tuesday, April 7, 2015

First Quarter Scorecard - Very Good!

The first quarter of 2015 has ended in a very satisfactory manner. Even though the major market indices were not up significantly in the first quarter, the smaller and mid-cap versions of stocks certainly did well. And for the first time in many years, the international markets have contributed to these gains.

Since 2008, the large-cap U.S. stocks have been the stand out performers. This is mainly due to their high level of liquidity and their international based sales force, which provided gains around the world. During the past couple years it was especially difficult for investors to beat the performance of Standard & Poor’s 500 Index of stocks. There was much publicity that investors should just buy indexes and forget them; the theory being if you bought low cost indexes, you could always beat (even the best mutual funds) with outstanding, long-term stock pickers. The first quarter of 2015 proved those critics incorrect.

Before I further discuss the title of this posting, I want to review some of the rather anemic numbers from the first quarter. The Standard & Poor’s Index of 500 stocks ended up with a slight gain of 0.9% for the first three months of 2015. While that certainly does not seem like much of a gain, it was still almost 4 times what cash would earn over the course of 12 months in this economy. The large-cap index has also recorded a 12.7% return for the one year period ended March 31, 2015.

The NASDAQ Composite had a much better performance, ending up 3.8% for the first quarter and having an 18.1% return for the one year period. The Dow Jones Industrial Average returned only 0.4% in the first quarter and 10.6% for the one year period. The small-cap Russell 2000 Index was up 4.2% for the first quarter and a rather lackluster 8.1% for the one year period. The Barclays Aggregate Bond Index was up 1.5% for the first quarter and up 5.6% for the year in March, 2015. As the above numbers clearly illustrate, it was the small and mid-cap stocks that were pushing the markets higher during the first quarter of 2015.

I meet with investors almost every day who lament the high volatility illustrated by the stock markets. I emphasize to them that you just have to try and ignore these wild swings in the market, since it is caused by short-term traders. These short-term traders are not concerned about economics, earnings or interest rates. They trade many times a day and in high-volume trades, trying to secure even the smallest percentage gain.

These are not investors, they are traders. Even though we have to coexist with them in the marketplace, at the end of the day they do not constitute long-term investing and don’t make a living making investment decisions based on long-term fundamentals affecting the economy. They trade based upon the smallest or most insignificant trend and/or economic news that they can find. I am often amazed at the explanations given for this high volatility. In most cases, it is almost completely meaningless to long-term investing. If, however, you attempt to invest in the way they trade, you will almost assuredly lose money over time.

A few pictures from Easter 2015 - enjoy!

The first quarter enjoyed very significant gains in many areas, but the large-cap indexes did not meaningfully participate. As I have indicated in these postings before, the three most important components of stock market investing are interest rates, the economy and earnings. There was no significant change in the direction for any of these major components during the first quarter, as all continue to develop in a positive trajectory.

As an example, the Fidelity Spartan Small-Cap Index fund finished the first quarter up a robust 4.3%, compared to the S&P 500, which was up 0.9%. The Spartan Mid-Cap Index was up 3.9% and the international index was up a very satisfying 5.3% for the first quarter. As you can tell, all of these indexes outperformed the broader S&P 500 for the first quarter. It was a very satisfying quarter in that the best fund managers in the world were able to outperform the passive major market indexes.

There are also many positive attributes in the U.S. economy that require your attention. It looks like interest rates are going to continue to stay very low. Basically, there are three ways of looking at interest rates: 1. going higher, 2. staying flat, and 3. going down. I think all of us could agree with the old football saying, “Three things can happen when you throw the football, and two of them are bad.” Arguably, you will not find too many investors who would argue that interest rates are likely to go lower for the next few years to come. If that is the case, when investing in bonds you have the potential to achieve a negative outcome with two out of three scenarios – not a very good bet.

For now, it looks like oil is going to stay low longer than I had originally thought. American ingenuity in producing oil has changed the ability of the oil cartel in the Middle East to control pricing. For the first time in over 80 years, the U.S. is producing oil quicker and cheaper than their counterparts overseas. It was once thought that the cartel could control the price of oil just by announcing production levels. With the unbelievable violence that is occurring in the Middle East, the U.S. has suddenly taken over leadership in producing oil and doing it very satisfactorily, at a much lower rate. It now looks like oil might be in a favorable selling range for many years to come. That is unbelievably bullish for the American economy.

Also, it looks to me like the building boom has picked up again. The price of housing has moved up, and there appears to be a serious increase in construction, both in housing and in non-residential construction. In fact, in looking at Barron’s economic statistics this weekend, one number literally jumped off the page. Building contracts, as reported by the F.W. Dodge Corporation, had year-over-year change of 49.33%. These are projects which are seeking builders. Although they are not currently being built, this index screams higher construction activity is literally on the books, but yet to begin.

The fourth quarter economic numbers were recently reported, with the GDP announced at 2.2% - a significant reduction from 5% growth in the third quarter. Also, it is presumed that the first quarter GDP for 2015 will be only marginally positive. The short-term traders are now touting that the U.S. economy has hit a dry spell and is likely to fall into recession.

It always defies common sense to me that people do not take weather into account on these economic numbers. For example, this year Boston had more snow than ever in its history. Do you really think people go shopping for a new car or out to eat as often in these weather conditions? You do not go to the mall if you cannot drive your car, which in turn negatively impacts retailers and their employees. Economic activity is down, but that just means there is some pent-up demand that consumers are likely to exercise this spring. The economic activity will come back; it is only a matter of time until the weather clears.

There are all kinds of positive economic numbers in the news. Personal income for the month of February was up 4.95%, year-over-year. This is the most significant movement in personal income in the U.S. in a very long time. Durable manufacturing continues to rise at an almost 4% annual increase. Consumer spending is quite robust with a 2.82% year-over-year increase. Even with significant weather effects, retail sales were still up in February, 1.69% year-over-year. Also interestingly, the personal savings rate has mushroomed 38% year-over-year. And in just one year the savings rate has gone from 4.2% to 5.8%. While I recognize that a 5.8% savings rate is not significant for one individual family, this is still a significant and positive move to the upside in the aggregate for all working Americans.

Not to bore you with economics statistics, but it was also reported in February that the inflation rate was absolutely zero. Therefore, for the first time in many years, the economy is improving, but with zero inflation. Of course, a major component making inflation zero is the significant decline in gasoline prices, which is helping American consumers increase their savings rate and also increase their ability to consume. As mentioned above, these indexes have moved up significantly over the last year and if you have more money in your pocket from spending less money on gasoline, you are benefiting from this improving economy and are actually able to save more for your future.

It is also interesting that investors, in typical fashion, are continuing to operate exactly the opposite of how you should in an improving economy. Over the past five months investors have pulled $18 billion out of domestic stock funds at Fidelity alone and added $24 billion to the bond funds. Further, almost daily you see financial headlines that would scare even the most active investor. Once again, it appears that the uninformed are reacting to negative headlines without reviewing economic reality.

A strong U.S. Dollar has implications on the investment environment. Regarding U.S. stocks, it appears that the small and mid-cap version of stocks may be the best performers going forward. These companies are more isolated from the currency markets because they are not as involved in international commerce. Moreover, the continuing economic expansion in the U.S. benefits small-cap stocks.

I am particularly interested in foreign economies now. Despite the fact that the European economy is not as productive or efficient as the U.S, it does not mean their markets do not present attractive opportunities. Their stocks have been chronic underperformers in recent years, and therefore have the potential to move higher compared to their U.S. equivalents.

In Asia the economy is turning around, also supported by the strong dollar in the U.S. Asia has the ability to export goods and services into the U.S. at a significant currency advantage. It looks like Europe and Asia will continue to move higher as the U.S. loses some of its market leadership. By increasing our international exposure, we hope to participate in these opportunities.

The one question I always get is whether or not the U.S. market is already in “bubble territory”. The evidence clearly indicates that is not the case. The large-cap S&P 500 is currently selling at a trailing price earnings ratio of 18.5 times earnings. Over the last 25 years, that index has traded at an average of 19.1 times earnings. While this rate is not cheap, it is not extraordinarily expensive either. But remember, as mentioned above, we believe the smaller version of U.S. stocks have the potential to outperform and we are emphasizing less large-cap version as represented in the S&P 500.

There are several ways to evaluate bonds. We believe most of the measures indicate that an adverse environment is likely to confront bond investors going forward. Right now, the dividend yield on the S&P 500 exceeds the interest paid by owning a 10-year U.S. Treasury bond. This phenomenon exists for only the fourth time in the last 50 years. Investors have a choice to invest in a 10-year bond that has the potential of losing significant inflation adjusted value due to low payouts and rising interest rates or invest in the S&P 500 that pays an equivalent, but more tax efficient, yield and is positively impacted by inflation and increasing earnings. Again, this is only the fourth time in the last 50 years that this economic phenomenon has occurred. In every case when it has occurred, there has been a significant rise in the equity markets over the next year. That is exactly where we stand today.

Therefore, to put it all into perspective, our three investing components are all positive. Earnings are growing, interest rates are low and any increase in rates over the next 12-month period is likely to be gradual. And most importantly, the economic growth is present and it looks like there is momentum as we may see additional economic growth as the year progresses. With these three positive economic components, it looks like my double digit increase forecast in the markets for 2015 are intact.

As the tax season ends, we will have more time to meet with you and discuss your portfolios and your economic future. We look forward to sitting down with you and going over these important statistics going forward. If you would like to meet with us, please let us know a time that is convenient to your schedule. There is nothing more important to your financial life than making sure that your financial goals and plans are firmly understood by all parties impacted by your financial future.

Also, the April 15th filing date closes out the 2014 year for making IRA contributions. It absolutely blows me away how many clients I have that tell me they do not make IRA contributions. Contributing to your IRA requires a rather small investment and is not likely to impact your current lifestyle. However, annual IRA contributions can have a great impact on your retirement lifestyle because of the most important economic force in the universe: the positive impact of compounding interest. So as April 15th rolls around, I ask “Have you made your IRA contributions for 2014, and if so, why not 2015?”

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins