Fourth Quarter 2014 Investment Commentary

A few big issues were significantly influencing investments at year end: (1) the plunging price of oil, (2) better economic indicators in the U.S. compared to the rest of the world, (3) the ongoing influence of central banks and (4) the rising U.S. dollar in relation to other currencies. U.S. large-cap stocks performed well during 2014 and core bonds performed reasonably well but practically all other asset classes performed poorly.

Oil prices hit five-and-a-half-year lows in late December after falling over 50% in less than a year (40% in the fourth quarter alone). New sources of supply along with potentially slowing global demand were mixed up with apparent manipulation in prices. A decline in oil prices is typically considered to be a good thing for the global economy, but the result this time around appears to be much different because of the speed and magnitude of the fall in the current fragile global economic environment. Deflation concerns are already high, especially in Europe, and the oil price decline is increasing the deflationary risks.

But the central banks helped the markets overcome concerns in the fourth quarter by continuing to artificially support stocks and other risky assets, just as they have many times since the 2008 financial crisis. Even as the Federal Reserve suggests it is on track to begin raising rates, it once again calmed markets by reaffirming that it would continue to be “patient” before doing so. In light of the poor economic conditions in Europe, investors continue to expect the European Central Bank to take a more meaningful step toward full quantitative easing. Central banks in Japan and China expanded their stimulative efforts during 2014. So, even as the Fed may begin scaling back its support, there appears to be no scaling back of support outside the U.S. But the fact that central banks continue to undertake aggressive action provides a reminder of the broader economic risks we must continue to consider.

The S&P 500 index gained almost 14% last year and, for the third year in a row, avoided even a modest 10% “correction.” On the other hand, U.S. small-cap stocks, dropped more than 13% from their summertime high through mid-October, but recovered to end the year up 5%. Other than in the U. S., most major stock markets performed poorly. Developed international stocks lost about 5% and emerging-markets stocks lost about 2%. The strengthening U.S. dollar weakened returns for dollar-based investors.

At the beginning of 2014, expert consensus was that interest rates would rise. But the 10-year Treasury yield actually declined and bond prices rose. The core investment-grade bond index was up 5.8% for the year and municipal bonds also performed well. But other sectors such as high-yield and floating-rate loans performed poorly. Core bonds include highly-rated corporates and treasuries. Currently the U.S. 10-year bond yield is at 1.9%, the German 10-year is at 0.5% and the Japan 10-year is at 0.3%. The 30-year U.S. bond yield stands at 2.5%.

For the past 70 years there have only been three other periods (out of a total of 51 ups and downs) where the S&P 500 has had a longer streak of gains without at least a 10% correction, according to Ned Davis Research. In addition, over the past two years, the S&P 500 has outperformed both developed international and emerging-markets indexes by an unusually large percentage relative to history.

Oil Related Issues

Oil and gas production make up a significant portion of employment, especially in Texas, and these are very high-paying jobs. The WSJ reported that they’ve paid more than twice the U.S. average weekly salary. Energy-related employment has been one of the few sources of strength in an otherwise sluggish labor market. Since the crisis, oil and gas jobs have grown by almost 50% compared to a 7% gain overall.

The energy sector has a significant indirect effect on other sectors. For example the Census Bureau reported a 1% decline in November manufacturers’ new orders, the steepest dip since March 2013. And on the same day U.S. Steel advised 756 employees that their jobs were at risk. The reason given was softening market conditions influenced by oil prices and trade. When the price of a commodity as essential to the economy as oil goes down by 50% in a year, bad things happen…somebody goes broke. It seems that what will be hit hard in the short run is oilfield investment spending on drilling rigs, supplies, crews and new acreage leases

U.S. Stocks

The U.S. economy looks to be in pretty good shape for the near term relative to foreign economies. (Someone has said, “It looks like the best house in a bad neighborhood”.) There are several positives: the labor market continues to strengthen a bit, inflation remains low, manufacturing indexes and other leading economic indicators suggest fair GDP growth, falling oil prices should boost consumer spending, and government fiscal policy is likely to give support as the effect of past budget cuts rolls off.

Earnings season begins today (01/12/14). According to FactSet, Wall Street analysts expect S&P 500 companies to report that profits rose a bit over 1% from the fourth quarter of last year. That would be the slowest growth since the third quarter of 2012. Fourth quarter profits have surely been significantly affected by plunging oil prices and a strong dollar. Energy companies’ profits are expected to fall by about 19%, and the rise in the dollar cuts into the value of revenue earned abroad. A strong dollar also cuts into the profits from exports because the export products have become more expensive in relation to foreign products.

But speculation still abounds. Margin debt compared to GDP is the highest in 85 years (margin debt is borrowed money used primarily to speculate in stocks and other risky assets.) The last two times margin debt was above 2% of GDP we had a market correction. Money raised by venture-capital firms increased 62% over 2013 to the highest level since before the crisis. Investors are obviously anxious to take advantage of a hot market for startup funding and initial public offerings, thereby pushing up the valuations. But there is plenty of talk of a bubble regarding this business. Can QE and ZIRP continue to keep the bubble bubbly?

European Stocks

The Eurozone continues to fight deflation. The December year-over-year headline inflation number fell to negative 0.2%, real GDP growth is below 1%, and two-year government bond yields in Germany and France are actually negative, meaning investors are paying the government for the privilege of owning these bonds. The European Central Bank has begun to expand its balance sheet again. The ECB president is expected to announce “whatever it takes” QE in a few days. And this time he really, really means it.

Emerging-Markets Stocks

There is a lot of negative news surrounding emerging-markets stocks—such as slowing growth in China and other BRICs and the decline in emerging-markets currencies. I think emerging market stocks will probably outperform U.S. stocks over the longer term, but I am very cautious about the short term downside risks and volatility.

Investment-Grade Bonds

I believe investment-grade bonds are likely to generate very low returns over the next five years. My opinion is based on the current very low yields and the probability of interest rate increases. A rise in rates seems certain but of course no one knows the timing or the magnitude of increases.

Floating-Rate Loans

Floating-rate loans still appear to be relatively attractive. Companies have taken advantage of historically low interest rates, locking in attractive levels for fixed-rate financing. As a result, there are only a few loan issuers with short-term maturities. It appears that companies have healthy levels of cash flow and interest-coverage. But, as always, there is plenty of potential for short-term downside risk

Market Neutral Strategies

I have spent a fair amount of time searching out the best of the best among market neutral fund managers. But our managers were only able to just about break even last year. Despite what has been a relatively poor outcome from our allocation to alternative strategies, I think the decision to own them was sensible given what were serious risks to the economy and stock markets at the time. As a reminder, the strategies in which we invest are intended to generate long-term returns that are better than core bonds, with much lower downside risk and volatility than stocks and relatively low or no correlation to stock and bond market indexes. Given the high valuations of stocks and all-time low interest rates, there is a reasonable basis for maintaining our allocation to these strategies.


Gold was down over 2% in 2014 but gold-related stocks were down well over 18%. Silver-related stocks were down even more. Gold stocks had a negative correlation to the rest of the stock market last year. Since late October, it appears that gold stocks may be staging a recovery.


The S&P 500 rose nearly 14% last year but the average hedge fund hardly rose at all. Since the end of 2008 the S&P has risen about 150% but the average equity-focused hedge fund by only about 40%. So, private investment partnerships are closing at the fastest pace since 2009 but money is pouring into Vanguard’s low-cost index funds. As a reminder, to hedge is to keep something back from the long side of the market primarily by holding cash or through the technique of short selling. For the moment central bankers continue to stimulate and asset prices continue to rise. So to hedge is to lose, or rather, to hedge has been to lose. Hedging is much the same as the purchase of property insurance. You send thousands of dollars to your insurance company year in and year out and yet your house is still standing. Of course the analogy is not quite the same…you don’t fire your insurance professional if you don’t have a claim. Despite QE and ZIRP, asset prices will continue to overshoot both to the upside and the downside. Deep on the downside, what will matter most is not the cost of investing but having the funds with which to invest.

Financial Crisis Revisited (?)

We have new regulations for mortgage qualification rules called “qualified residential mortgage” (QRM) rules. Following the 2008 financial crisis, governmental agencies enacted tougher rules to regulate the very lax and abused mortgage qualification process. That meant lower profits for the big banks and realtors. So they organized to push for a return to easy qualification in order to allow buyers to do away with pesky things like good credit and down payments. Fannie and Freddie now have mortgage programs with down payments as low as 3%. With 3% equity, homeowners will be underwater at the slightest market downturn. That puts more risk on lenders, and ultimately taxpayers, by the same sort of conditions that contributed to the financial crisis.

But the relaxed lending rules haven’t lit a fire under the real estate market yet. That may be because wages are stagnant in nominal terms and lower in real purchasing-power terms. ZIRP and digital wampum have succeeded in inflating home prices. There appears to be no limit related to reality as to how high stocks can be inflated but housing is still subject to reality: inflating prices beyond the reach of homeowners kills sales.

According to a recent WSJ article, about 8.4% of borrowers with weak credit scores who took out car loans in the first quarter of 2014 had missed payments by November. That was the highest level since before the crisis of 2008. Hmmm. The car loan market is not big enough to have an impact similar to the mortgage crisis, but the point is the same. Auto loans outstanding are up nearly 30% from the post-crisis bottom. So it would appear that the big recovery in auto sales is due, at least to a significant extent, to easy credit.

The U.S. Dollar

Foreign governments are weakening their currencies, therefore the U.S. dollar continues to rise by default. The Organization for Economic Cooperation and Development (OECD) in its recent semiannual report stated that Europe is in a “persistent stagnation trap”. They propose that lower exchange rates are the way forward. They also propose that the U.S. dollar should slide: “The policy interest rate path may also need to be modified depending on financial conditions”. The world’s central bankers print money, weaken their exchange rate, raise up exports, lift asset prices and thereby boost “aggregate demand”. But, try as they might, all the central banks can’t devalue every currency, all at the same time, against each other. Almost half the sales made by companies in the S&P 500 are exports. A stronger dollar makes exports more expensive to the buyers.

Concluding Remarks

Of course I have given a lot of thought to the market manipulation by global central banks, pushing financial asset prices up in order to create the “wealth effect” and making people happy, happy, happy so they will spend and postpone the inevitable. A few months back, most of the experts appearing on financial TV were calling it “kicking the can down the road”. I’ll bet most of them have never kicked a can down the road. I have…and as I remember, the can always ended up in a ditch. Now it seems that what is extremely abnormal has been accepted as uncomfortably (at least for me) normal.

I remember a time when the stomach virus went around at my house. I had a great idea…at the first sign of the virus, I took anti-nausea drugs that I had on hand from the last time. I would avoid the crisis and humiliation that result from the stomach virus. So, I did not regurgitate. But…a week and a half later I was still sick with the 24-hour virus. And then it happened; I regurgitated…and it was ugly. At one point I thought I had thrown up my toenails. I learned a valuable lesson that day; sometimes you just have to let Mother Nature take its course, get over it and move on. The longer you postpone the inevitable, the worse it gets. I wish I could relate that to the 50-something PhDs at the Fed.

Thank you for reading. Thank you for the opportunity to serve.

The LORD bless you and keep you; the LORD make his face shine upon you and be gracious to you; the LORD turn his face toward you and give you peace. Numbers 6:23-27

God bless you,

Gary Clark

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