The stock market was up in the fourth quarter bringing an end to a surprisingly good year.
The U.S. economy proved it could thrive even as the Federal Reserve ended its bond buying program which had been intended to aid growth by holding down long-term interest rates. All told, the United States remained insulated from the financial struggles surfacing everywhere from Europe and Latin America to China, Japan and Russia.
The U.S. economy flexed its old muscles in 2014 although it did not start out that way. More than five years removed from the Great Recession, worries had taken hold that perhaps the world’s largest economy had slid into a semi-permanent funk. Consumers, businesses and investors, after enduring a brutal winter, showed renewed vigor, however, as the year wore on and set the United States apart from much of the world. Stocks repeatedly set record highs. Employers were on pace to add nearly 3 million jobs, the most in 15 years. Sinking oil prices cut gasoline costs to their lowest levels since May 2009. Auto sales accelerated. Inflation was historically low at sub-2 percent.
So what explained the U.S. economy’s resilience this past year? Economists say it largely reflected the delayed benefits of finally mending the damage from the worst downturn in nearly 80 years. Unlike past recoveries that enjoyed comparatively swift rebounds, this one proved agonizingly slow. It took 6 ½ years to regain all the jobs lost in the recession-8.7 million-far longer than previous recoveries. The healing isn’t complete. Wage growth remains lackluster and average incomes have declined over the past five years. This is despite extremely low inflation. Home building has been tepid at best. Nevertheless, 2014 turned out to be a better year than expected.
As 2015 begins, investors face a divided landscape: an improved U.S. economy and weakness just about everywhere else. But unlike the past year when U.S. markets were a winning bet, many think U.S. stocks and bonds will have a harder time maintaining their lead.
During the second half of 2014, the U.S. economy at long last gained more traction and U.S. stocks raced ahead even as the Federal Reserve ended its post crisis stimulus. The Dow Industrials rose for the sixth year in a row. The S&P set numerous records as it closed out the year.
It is likely that we are in a secular, not a cyclical, bull market. Secular bull markets, like from 1949 to 1969 and 1982 to 2000, are extended bull markets characterized by above-average annual returns and generally less dramatic downside risk. This does not mean that this market is immune to corrections but it shares characteristics of past secular bull markets. For instance the S&P 500 has posted an annualized return of 22% in the first four years of this bull market. This closely mirrors the first four years of prior secular bull markets which had similar returns. Economic characteristics of past secular bull markets at their outset include secular valuation lows, secular unemployment rate highs and negative real interest rates. All three characteristics also were in place at the beginning of the current bull market.
The “deleveraging” period since 2008, when consumers were focused on paying off debt, is largely over. This is why consumer spending has been recovering. It is not likely to reach prior lofty levels due to the lingering memory of the debt crisis and a general increase in frugality. But with consumer free cash flow in the rise, due in part to lower energy prices, consumer spending (accounting for 68% of U.S. GDP) should remain relatively healthy and could even accelerate more than income growth.
We can also look at the market’s underlying fundamentals. S&P 500 earnings have tripled since March of 2009 while the stock market is up a lesser 240%. On both a trailing and forward basis, the market is about at historic median P/Es while most of the macro conditions supporting higher valuations remain in place. Many have argued the multiples have risen “artificially”, meaning they have been pushed up by risk-seeking investors and record-low interest rates. Interestingly, though, multiple expansion in this bull market has been about average for bull markets since 1957. So why have stock market returns been so high? Earnings. Earning growth in the current bull market has been 20% above the average level of growth for all bull markets since 1957.
What could spark volatility? One catalyst in 2015 could be interest-rate uncertainty as the Fed moves toward an initial rate increase. The onset of Fed tightening cycles has not upended bull markets historically, although they do usher in bouts of volatility and pullbacks. In the two most recent tightening cycles, during the mid-1990’s and the mid-2000’s, the stock market performed admirably. There were five corrections or pullbacks during each cycle. The corrections average -12% in the mid-1990’s cycle while the average pullback was -7% in the mid-2000’s cycle. Every initial rate increase since the early 1960’s shows the market was weakest several months before the initial increase, but the market’s performance is largely higher over the full year.
Consumer spending represents about 2/3 of the U.S. economy. Oil and gas capital expenditures represent less than 1% of U.S. GDP. Therefore the benefits of lower energy prices (oil is down about 50% this year) to the consumer and many businesses greatly outweighs the significant hit to energy companies. Lower energy prices also hold down overall inflation, which is a plus for both the U.S. economy and the stock market. Lower inflation has historically meant higher equity valuations. In fact, there is a direct inverse correlation between the energy sector’s weight in the S&P 500: a lower weight, typically as a result of lower energy prices, has led to higher overall S&P 500 P/E ratios, and vice versa.
Therefore as energy stocks decline, the overall S&P has a higher P/E ration and opportunity for further advances.
Finally, is a strong dollar good for the U.S. stock market and economy? During 2014, the U.S. dollar gained 11%, the highest return it has had since 2005. The conditions supporting the U.S. dollar resemble those that drove the dollar bull market of the 1990’s. Most of these conditions had a positive effect on the stock market. Thus, the dollar and the stock market were positively correlated. This correlation has recently moved back into positive territory and we believe it will remain there.
This is in contrast to the early 1980s when runaway inflation and double-digit interest rates drove the dollar higher-not positive conditions for the stock market. During the 2008 financial crisis, a higher dollar was the result of its safe-haven status amid a crumbling global financial system- also not a positive condition for the stock market. During these phases of dollar strength the stock market was inversely correlated to the moves in the dollar.
As far as the economic impact, while a stronger dollar makes exported goods more expensive, exports represent only 13% of U.S. GDP, compare with 68% for consumer spending. Since many commodities, notably oil, are priced in dollars, a stronger dollar means lower commodity prices, which is good for consumption-oriented economies of countries like the United States.
All of the conditions outlined above point to another successful year for equities and the stock market. It is our opinion that the bull market will continue, however, not as robust as it has over the past several years. We expect gains in the area of 7-8%, price increases of 5-6% and dividends of 2%.
Bruce A. Kraig, MBA, CFP
Kraig Investment Management An unbiased, independent RIA serving our clients' best interests since 1991 Wealth Management...Retirement Planning...Financial Planning 1650 Fox Crossing . West Chester . Pennsylvania . 19380 610 . 644 . 3468 Info@KraigInvestmentManagement.com