Markets

Looking Back on 2014, Forward to 2015

These records might lead you to think 2014 was a banner year for the entire U.S. stock market, but that isn’t the case. It was a banner year for certain market segments, mainly a few dozen large-cap growth stocks. Yet it was a surprisingly tough year for small cap U.S. stocks and for almost all non-U.S. markets.

The difficulties were most evident in smaller stocks. The Russell 2000 lagged badly for most of the year, ending with only a 3.5% gain according to preliminary data. In contrast, the S&P 500 Index of much larger companies rose approximately 11.4% for the year.

Why the difference? No one knows for sure, but we suspect it relates to global capital flowing into dollar-denominated assets. Owners of this “hot” money want to stay liquid, so they keep their equity allocations in relatively stable large-cap growth stocks that they can sell quickly.

We should also note that the Russell 2000 significantly outperformed the S&P 500 in 2013. The gap is much smaller over the full two-year period. The passage of time tends to resolve most such discrepancies within a few years.

The recent bias toward large cap growth may explain why 2014 was tough for some top mutual fund managers. Investor’s Business Daily tracks an index of 20 popular stock funds. You can see in the chart below that they went collectively sideways over the last six months. For the year through Dec. 30, the average gain of those 20 funds was only 3.04%. Six of the twenty funds were at 0% or less.

IBD-MF-Index

Our Republic Wealth stock programs take a different approach. We seek to control risk by reducing exposure in downturns and concentrating on market segments with higher relative strength. This year’s leaders included health care (especially biotechnology), utilities and technology stocks. Energy stocks performed well early in the year but fell hard in the last quarter.

What do we expect for 2015? While there will be bumps in the road, we still believe the U.S. economy is in a sustainable “plow horse” recovery. Lower fuel prices will add to consumer spending power that was already looking up as the labor market improves. Growth in asset prices, particularly real estate and stocks, is encouraging wealthy Americans to spend and invest more freely.

The biggest question mark is whether, and when, the Federal Reserve will begin hiking interest rates. Analysts we trust think that the Fed will act in mid-2015 with a series of small rate increases. Ideally, Janet Yellen and her colleagues will act firmly enough to control inflation fears but at slow enough pace to avoid discouraging growth.

Energy prices will be another important factor. If crude oil stays below $60 as it is now, drilling activity will decline at higher-cost shale sites. The reduced capital spending will trickle through the economy as previously well-paid workers lose their jobs and companies stop buying supplies.

Much also depends on events overseas that no one can predict. Last year we had surprises, namely Russia capturing parts of Ukraine as well as the Islamic State’s rise in Iraq and Syria. Neither had a major market impact, but 2015 could certainly bring more surprises.

We think that what really counts is whether businesses can sustain and grow their bottom-line profits, and the answer will be “Yes” in 2015. Business owners and executives will keep investing in the future, driving fundamental value higher for shareholders. Corporate executives have learned how to play Wall Street’s expectations game. They make low-ball forecasts so they can deliver pleasantly surprising earnings reports.

Meanwhile, the fixed-income alternatives will remain difficult despite a more hawkish Fed policy. Short-term yields will likely go higher, but not enough to outweigh the superior upside potential in stocks. Dollar strength may keep long-term rates low as well, making stocks even more attractive in comparison. As always, we will stay flexible and consider new information, but we are optimistic for 2015. Cyclical patterns suggest it could be a great year. Soon we will see it begin.

 

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