|12 Mo. Change||YTD Change|
|10-yr Treas. yield||2.17%||2.51%||-0.34%||3.03%||-0.86%||-0.86%|
|Fed funds rate||0 to.25%||0 to.25%||n/a||0 to.25%||n/a||n/a|
(stock indices are before dividends; yield and rate changes are absolute changes)
Despite a slide on New Year’s Eve, a Santa Claus rally lifted the US stock market to a respectable return for the quarter. This was despite two slumps in October and December, with October flirting with the 10% “correction” level before investors came back into the market to buy on the dip. For all of 2014, the S&P 500 did not decline for four trading days in a row, but international markets continued to suffer from weakening growth and currency declines against the US dollar. Interest rates fell again after a brief increase as investors flocked to the safe haven of the US.
While they have been whittling away for the last few years, the government closed out is auto-company bailouts from the recession with its sale of its stake in Ally Financial, the former financing arm of GM. There are still 35 small banks left in the bailout program and the government still controls mortgage lenders Fannie Mae and Freddie Mac, but the overall bailouts have returned just over $441 billion on $426 billion invested.
In October the Fed ended its quantitative easing programs (QE) as expected, noting “underlying strength in the broader economy” and overlooking short-term market volatility and weak inflation. The year-end rally was then stoked by the Fed, which added the word “patient” to its statement of taking “considerable time” to raise rates, which led the market to extend its timeline for higher rates. Then, the final revision for third quarter GDP growth was increased to 5% from the prior 3.9% estimate, the highest quarterly growth figure in 11 years and exceeding the second quarter’s 4.6%. The change was largely driven by higher consumer spending, particularly on health care, and GDP grew 2.7% on a full year-to-year basis.
The other driver was the unexpected and precipitous 50% drop in the price of oil since June, which continued into 2015. The price of gasoline dropped below $2 in a number of states and the US has begun exporting oil to Asia which has been only lightly processed, the first exports since the 1970’s. As noted in Looking Forward, lower oil prices have racked the global oil power structure and brought Russia near collapse. Even an increase in Russian interest rates to 17% from 10.5% did not slow the ruble’s 50% drop, and the US dollar hit five-year highs against a broad currency basket and three year highs against the euro.
Europe struggled with lower growth forecasts, France’s credit rating was cut by Fitch and even Germany, the bright spot in Europe, slowed considerably. Japan officially entered recession with its second consecutive quarter of GDP contraction and China cut interest rates further to prop up growth. Greece’s government did not receive majority support and new elections will be held, rekindling fears that Greece will default and perhaps leave the EU. President Obama announced that the US and Cuba will now work to normalize relations, reversing over 50 years of conflict. At the same time, US and NATO military operations in Afghanistan, officially America’s longest war, became support and advisory only and more resources were committed to fighting the Islamic State in Iraq and Syria.
The US economy was the global bright spot, with employment continuing to strengthen, manufacturing jobs growing and official unemployment at 5.8%. Still, hourly earnings grew only 2.1% in the last year and the broader unemployment measure including part-time and marginal workers is at 11.4%, with the labor participation rate still weak at under 63%. Consumer confidence and non-real estate debt both grew, with debt driven by student and auto loans and total debt including real estate was just below the 2008 peak. Productivity growth was strong, labor cost increases are modest and both manufacturing and service growth indicators are quite strong.
On the domestic political front, the Republicans did indeed take control of both the House and Senate and the internal battle to see if they can effectively govern is underway. And while the mechanics of Obamacare seem to be working acceptably, it will be a few more years before the jury is in on whether it is a positive development that will become permanent.
The decline in the price of oil is generally seen as a positive for the economy. Consumers have more cash in their pockets a result of spending less on gas, leading to predictions of increased spending in other areas. This is particularly true because the short-term elasticity (that is, changes in behavior and consumption patterns) of oil is relatively low and the lower cost goes right into consumer pockets. Lower oil prices have also sent a shock wave through the established power structure of oil, lessening OPEC’s power, increasing US clout and putting tremendous pressure on Russia, which is essentially a one-product economy.
There are some downsides to lower oil prices. The oilfield activity and hiring that has been a strong driver of the US recovery could slow down, and the ability of other industries to pick up the slack is unclear. In the long term, there is elasticity in the demand and use of oil, and longer commutes, more travel and other changes could backfire for consumers if the price recovers. Sales of SUV’s and other low mileage vehicles are already picking up and miles driven were up 2.6% in October for the year prior. All these changes have environmentalists concerned about not only the long-term effect of global warming but the short-term impacts of more oil trains, water supplies, etc.
Some backlash to the oil boom is already evident. The Keystone pipeline has been stalled for years and it is unclear whether President Obama will go along if the Republican Congress approves its construction. After several years of a moratorium, New York implemented an official ban on fracking across the entire state, in contrast to neighboring Pennsylvania which has seen huge fracking activity. Individual communities across the country have enacted similar bans, even in such energy-friendly states as Texas. And just after the New Year, Saudi Arabia cut the price of its oil to European customers in an apparent attempt to maintain their market share and offset the growing US supply. This comes only weeks after OPEC previously declined to cut output to keep prices from falling further.
The decline in the price of oil took markets largely by surprise, certainly in its speed and degree. Just when the reasons seem obvious and the episode appears to be closed, markets have a pesky tendency to once again confound observers. It will be very interesting to see where the price of oil goes from here.
(Somewhere out there is an investor – probably an institutional investor or hedge fund genius – who placed huge losing bets on both the price of oil and the ruble, but that’s a story for another time. Except to say, again, that we will never be that investor.)
There are plenty of traditional portfolio techniques which are alternatives to active trading and “stock-picking”. One of the oldest and most popular is the “blue chip” strategy of selecting a number of well-established companies with long records of profit growth and dividend payments and holding the stocks regardless of what the market does. The idea is that the strength of these companies will protect the portfolio from significant losses while the dividends will grow over time.
Like all investment strategies, this approach has its own risks, the greatest of which is complacency. The 2008-2009 recession exposed the flaws in the strategy, with all financial firms suffering mightily and many cutting dividends to nearly nothing. Even diversified firms such as General Electric were pummeled and some former blue chips such as GM declared bankruptcy.
That episode could be dismissed as a once-in-a-lifetime market disruption, but that would be a bit simplistic. Take the most recent quarter as another example, one in which the overall market was unexpectedly strong. It’s fair to say that Coca-Cola, McDonald’s and IBM would all be considered blue chip companies. But all three stumbled badly, with Coke having slow sales growth and growing health concerns over its core product, IBM falling short of earnings expectations and McDonald’s also having slowing sales and stagnant product offerings. IBM fell over 15% in the quarter and both Coke and McDonald’s badly lagged the overall market for the year.
In fairness to the companies and the blue chip strategy, they have all had growing dividends and there are not yet indications that those dividends will be cut. But it is a shock to see declines when the market is otherwise strong and it is a good idea to ask whether they have growth prospects in the future. Nobody wants to be stuck with a large position in another GM out of blind faith.
In the interest of full disclosure, our broadly-diversified and balanced portfolio approach does have risks. For one, any broad market area could have significant losses in the short and intermediate terms. For another, personal circumstances could unexpectedly and dramatically change in the midst of a market disruption. The biggest risk is that the portfolio allocation is simply inappropriate and either too conservative (not providing the necessary growth) or too aggressive (pursuing potential returns that are not actually needed).
We acknowledge those risks and address them through candid discussions with clients to make sure they understand the risks and opportunities associated with any investment. We also emphasize that the portfolio should not be expected to compensate for fatal flaws in other financial areas such as spending, saving or unrealistic expectations. That comprehensive approach makes it more likely that the portfolio actually works in support of broader financial goals rather than having a life of its own.
The Home Front
The real estate collapse and related borrowing was a key factor in the recession. After five years, how is the real estate market looking these days? In a word, mixed.
Housing has been a big contributor to recent inflation figures, with rents and imputed rents raising inflation to 1.7% from 0.9% without housing. On the other hand, Fannie Mae and Freddie Mac returned to more sloppy lending practices by guaranteeing mortgages with a 3% down payment from the previous 5%. They also relaxed the rule that banks had to keep 5% of mortgages on their books, which was thought to be a disincentive to sloppy lending, instead of selling them.
The latest sales figures from November show a decline in new home sales from the prior month and only a 0.2% increase from 2013. Existing home sales were also down 6% for the month to a six-month low and were up only 2.1% from the prior year, with the median price up 5% for the year and listings also dropping to a 5.3 month supply. Overall, sales for the year are still 500,000 below the level considered to be a healthy market and nationwide prices are still 15% to 17% below the market peak in 2006.
One concern is the level of first-time homebuyers at 33% of sales, the lowest in 30 years and well below the long-term average of 40%. This is significant because first-time buyers enable current homeowners to “trade up” to other homes and thus have a disproportionate impact on the larger market. There are an estimated 875,000 more households of young adult renters that there would have been if pre-recession buying trends had continued, according to real estate website Trulia. And the millions of young adults still living with their parents are more likely to rent when they leave the nest before they buy a home. Add the interest in living in high-priced areas like San Francisco and other cities, and construction of new apartments is at its highest level in 25 years, far outpacing new home construction.
Of course, all real estate is local, and both home prices and sales in Tucson flattened in 2014. The median price reached $165k, well above the low of $115k in 2011, but up only 5% from 2013. (Our friends up north in Phoenix saw a more dramatic slowdown, with prices up 18% in 2013 for the prior year but up only 1% in 2014 for the prior year.) Foreclosures are way down but are still around 20% of the market and a similar 20% of homeowners are still “underwater”, or owe more than their home is worth. While there may be pockets of high demand, Tucson has not had as many anecdotes of buyers being shut out of their desired neighborhoods. The market still has a way to go to reach a demand and supply balance.