4Q 2014 Market Commentary

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Market Commentary
By The Deighan Team

2014 wrapped up the year with market and economic imbalances all over the place. However, if you ask the average investor, 2014 was a “good year for the market” thanks to a fourth quarter rally that helped close the S&P 500 up 13.69%. Certainly, for US residents, the year-end results looked good for the home team, but the final score included too many “Hail Mary passes” to merit resting easily on laurels. Remember the hand wringing only a few months ago in October when even the S&P 500 had lost more than half of its gain for the year? While the fourth quarter rally saved the day, or rather, the year, it is important to remember that December 31st provides only a snapshot look at any and all markets during a year in which we experienced significant volatility. Now, in early January we are dealing with another slide off, followed by another rally, and so on and so on. As we have said before, volatility is the new normal.

Investment returns across global broad asset classes can be described as “haywire.” Take a look at the chart below to get a sense of the divergence of 2014 returns in some of the major markets:

Asset Class Representative Index 2014 Return
US Large Cap Equities S&P 500 13.69%
US Small Cap Equities Wilshire 4500 Completion 7.94%
Developed Internat’l Equities MSCI EAFE (Net) (4.90%)
Emerging Internat’l Equities MSCI EM (Net) (2.19%)
Alternative Equities HFRX EH Equity Market Neutral 3.63%
Hard Assets Bloomberg Commodities (17.01%)
Broad Fixed Income Barclays US Aggregate 5.97%
Cash Equivalents BOA/Merrill Lynch T-bill 3 Month 0.03%

US Large Cap Equities clearly lead the way in 2014, a reflection of the continued US economic recovery. However, the joy was not extended to Developed International Equities. Both Europe and Japan continue to struggle against multiple headwinds and have not yet recovered from the 2008-2009 financial crisis. On the encouraging side, both have finally instituted quantitative easing programs, imitating the US Federal Reserve Board’s strategy that worked well for the US. Commodities were off sharply primarily as a result of falling oil prices which dropped more than 50% in 2014. Although not showing on the chart, most foreign currencies have plummeted versus the dollar. This is partly due to the fact that the US economy has recovered reasonably well in contrast to other world-wide economies. Thus, the strong dollar further punished international ex-US investments of all types. Finally, the 2014 broad US fixed income results surprised most investment professionals. Over the course of 2014, the Fed has stopped propping up the US economy with expansive monetary policy, and has signaled that it will start raising the Federal Funds rate in 2015. In a rising interest rate environment, simple mathematics would dictate that the prices of bonds go down. Thus, the 2014 upward price movement of long maturity, high quality US bonds had to be fueled by a flight to quality. In other words, the seagulls are flying inland. Could they be sensing an impending storm?

Perhaps our seagulls are viewing a massive oil slick. While consumers may be cheering the price drop every time they fill their gas or oil tanks, they may not be seeing the bigger effect low oil prices will have on their lives and their investment portfolios. Much of the economic renaissance in the US has happened in the Midwest and Western states as a result of increased oil exploration attendant to our desire to become energy independent. Only last month, I overheard a conversation among some well respected Maine business owners as they were saying that oil truck drivers n the Midwest were making $100,000 a year and if they were young, they would move out there and take advantage of the boom. Regardless of whether the high price tag for low skilled labor is true, the boom mentality was certainly apparent. The fact is, extracting oil and gas from shale or fracking, is not cheap production. So long as oil prices remain relatively high the numbers work, but when the extraction becomes unprofitable because cheaper oil is available elsewhere, the businesses that have arisen to service the local industry will eventually crumble with the falling oil prices. As we ponder oil prices, I am reminded of “The Wizard of Oz” and Penobscot Theatre’s excellent, ambitious December production. The Tin Man needed his oil can to survive, but he wanted a beating heart to become real. In the early production of the play almost 100 years ago, many thought the Tin Man was a parody for John D. Rockefeller, joking his world would really freeze up if he didn’t get the oil he needed, but what he needed most was a heart. I am not sure who the Tin Man might be in the current scenario. I am more interested in who might be the “man behind the curtain” pulling the levers and why. The Saudis, our long time allies, say they have two years of cash reserves, and show no signs of slowing production. Some analysts see the current oil glut as a “shot across the bow” to US producers touting US energy independence. Others cite lower worldwide demand for oil due to economic slowdown as the primary driver of lower oil prices. None of it is particularly upbeat. If the Saudis are the primary drivers behind lower oil, they can starve out the more highly leveraged US and Canadian producers precipitating a bust in our home grown energy boom. Even if the reason for lower oil prices is lower demand, then we had better hope the accommodative monetary policies of the Eurozone and Japan, in concert with cheap energy, jump starts their economies as well as those of emerging nations who are not overly dependent on energy production. After all, more than ever, it is a small, small world and eventually trouble in one area bleeds into another. One dividend of the falling oil prices may be increased effectiveness of economic sanctions placed on Russia for its aggressive posture in the Ukraine. The ruble has taken a terrible drubbing in 2014, but Putin is a tough leader, and too much provoking of a wounded bear could have difficult consequences too.

During a recent interview, Christine Benz of Morningstar cited the top issues that caught the investment community off guard in 2014: rapidly falling oil prices, the strong US bond performance given the Fed’s clear stance to increase rates, and the strong performance of the S&P 500 Index despite the volatile year. For active managers, it was a confounding and tough year. Looking ahead, the watchwords for 2015 are continued volatility and the exercise of caution. Against this backdrop, as we rebalance portfolios, we will be emphasizing security quality and portfolio durability. Twenty years ago when we launched the firm we said, “We want to build durable portfolios that will withstand the test of time for our clients.” That objective is as important to us today as it was the day we opened our doors, and that is where we will continue to place our focus. As always, please call us with your questions or thoughts. Best wishes for a sound 2015.

Happy New Year, from the Deighan team!