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Investment Letter

1st Quarter 2015

 
Blooming flowers, twittering birds, and warmer temperatures are euphoric signals indicating the gloom of winter is finally gone.  The beauty of the spring season has been a welcome distraction from the unpredictable and wild ride in the financial markets during the first quarter of 2015. 

The Dow Jones Industrial Average (DJIA) started off the quarter with a volatile month of performance in January, a February upswing leading to a new record close, and a return to unstable conditions during March to end the quarter at 17,776.12.  While the index had a total return (including dividends) of +0.33%, the index actually ended 47 points lower than the December 31, 2014 close.

The S&P 500 Index experienced a similar roller coaster like journey during the quarter.  After a market rally during February, the S&P climbed to a new record close of 2,117.39 on March 2, 2015.  The index gave back most of the gains over the next month and just squeaked out a first quarter total return of +0.95%.  The volatility during the quarter almost broke a long period of consecutive quarterly gains for the index, but the streak continued intact.  The 9thquarterly gain for the S&P 500 index is the longest period of consecutive gains since the stretch of 14 quarterly gains from the first quarter of 1995 to the second quarter of 1998.  The streak is important because it demonstrates the long period of positive returns investors in domestic large company stocks have enjoyed.  Going back to the market bottom on March 9, 2009, the price of the S&P 500 Index has increased approximately 205%, an outstanding six-year run for stocks.   

The table below recaps the 1st Quarter performance of other major indices:

 

Asset Class

Index

 1st Qtr. 2015 Total Return

Cash

ML Three-Month U.S. Treasury

0.00%

U.S. Bonds

Barclays Intermediate-Term Treasury

1.28%

U.S. Large Co. Stocks

S&P 500 Total Return

0.95%

U.S. Small Co. Stocks

Russell 2000 Total Return

4.32%

International Stocks

MSCI EAFE (net div.)

4.88%

Real Estate

DJ Select Real Estate Securities Total Return

4.71%

     
 Economic growth in the U.S. has been slow but resilient.  The most recent data showed 4th Quarter GDP increased at an annual rate of 2.2%.  Harsh winter weather conditions, the West Coast Port stoppage, a strong dollar, and low oil prices contributed to a lackluster performance in the manufacturing and employment sectors this quarter.  The strong dollar and lower oil prices have also been a drag on corporate earnings and business spending.  The good news is the recent lull will probably be more of a temporary setback as economic conditions should improve during the coming months.  Warmer weather, lower gas prices, and strong household wealth may also contribute to a rebound in consumer spending.  In fact, the economy is already seeing signs of this improvement as vehicle sales, mortgage applications, and pending home sales increased in March.  Despite some soft economic data during the quarter, conditions in the U.S. are still in good shape.

Economic conditions overseas are getting better.  The Eurozone showed signs of improvement as economic activity gained momentum during the quarter.  The European Central Bank (ECB) embarked on their Quantitative Easing program and all indications are that the stimulus is proceeding smoothly.  The economic fate of Greece and the future of Ukraine and the Baltics are major issues that will have to be addressed going forward, but the overall region should start seeing a broader and stronger recovery.  In Asia, the Japanese economy is still struggling but signs of improvement are starting to appear.  The 2014 consumption tax increase to 8% and improved corporate earnings should help boost tax revenues which in turn will aid in improving Japan’s fiscal health.  China is still growing but the double digit growth rates they enjoyed for years have ended for now.  The government’s commitment to economic reforms should help China achieve slower but more sustainable economic growth.  Elsewhere, Emerging Market economies are still a mixed bag of fortune and variations in economic prosperity remain country-specific.

Data from the Federal Open Market Committee (FOMC) meeting confirmed that domestic economic growth had “moderated somewhat”.  The FOMC also stated that labor market conditions improved, unemployment was lower, inflation declined further, export growth weakened, business fixed investment was advancing, lower energy prices boosted household purchasing power, and the recovery in the housing sector remained slow.  Further, the Committee expects economic activity will expand at a moderate pace and labor markets will progress toward maximum employment and price stability with appropriate policy accommodations.[1]  Of course, the big question is the timing of first rate hike since 2006.  The Fed has made it very clear that an increase in the federal funds rate will depend on further improvement in the labor market and medium-term inflation moving towards their 2 percent objective.  Based on this, the FOMC decided to keep the federal funds rate at the current target range of zero to 0.25 percent, and they stated that a decision to increase the federal funds rate remains unlikely at the next meeting in April.  That means the June, July, or September meetings could potentially be the start date for the Fed’s highly anticipated rate hike.

Our outlook for the global economy remains sanguine.  We believe the domestic economy will continue to grow at a rate that is low and slow.  The current bull market has survived to see its sixth birthday and we are optimistic that it will make it another year and hopefully more.  On a cautionary note, equities are more fairly valued than they have been in years and the long-run of market prosperity without a correction is worth noting.  The strong dollar and lower oil prices will continue to impact corporate earnings which could adversely affect stock prices.  We think the recovery will continue at a modest pace, but investors should not assume the market will deliver returns like we have seen the last several years.  We expect the dollar to maintain its strength relative to other foreign currencies, and we anticipate some improvement in international economies due to the decline in oil prices, weaker currencies, and more accommodative monetary policies.   

We assume the FOMC will raise rates later this year, and that a Summer/Fall rate increase will be the first in a series of hikes to bring interest rates back to a normal level.  The effect on investors should be minimal at first.  However, as the federal funds rate moves higher, the cost of financing debt and purchasing goods (homes and cars) will increase, but liquid assets (certificates of deposits, money market funds, savings and checking accounts) will benefit after earning next to nothing for several years.  Economic conditions, the strength of the dollar, and unforeseen geopolitical events will influence the Fed’s rate hike timetable for 2015. 

The first quarter was evidence that market volatility has increased, and we expect periods of pullbacks and recoveries to be more frequent for the financial markets during the next year.  While the swings may not always be extreme, the frequency is significant enough to make any investor pause.

The table below illustrates some of the significant volatile moments in the DJIA and the S&P 500 Index during the first three months of 2015.

DJIA

S&P 500

Date

Value

 Index Change

% Change

Date

Value

 Index Change

% Change

12/31/2014

  17,823.07

12/31/2014

    2,058.90

1/6/2015

  17,371.64

-451.43

-2.53%

1/6/2015

    2,002.61

-56.29

-2.73%

1/8/2015

  17,907.87

536.23

3.09%

1/8/2015

    2,062.14

59.53

2.97%

1/15/2015

  17,320.71

-587.16

-3.28%

1/15/2015

    1,992.67

-69.47

-3.37%

1/22/2015

  17,813.98

493.27

2.85%

1/22/2015

    2,063.15

70.48

3.54%

1/28/2015

  17,191.37

-622.61

-3.50%

1/28/2015

    2,002.16

-60.99

-2.96%

1/30/2015

  17,164.95

-26.42

-0.15%

1/30/2015

    1,994.99

-7.17

-0.36%

2/5/2015

  17,884.88

719.93

4.19%

2/5/2015

    2,062.52

67.53

3.38%

2/20/2015

  18,140.44

255.56

1.43%

2/20/2015

    2,110.30

47.78

2.32%

3/2/2015

  18,288.63

148.19

0.82%

3/2/2015

    2,117.39

7.09

0.34%

3/11/2015

  17,635.39

-653.24

-3.57%

3/11/2015

    2,040.24

-77.15

-3.64%

3/20/2015

  18,127.65

492.26

2.79%

3/20/2015

    2,108.10

67.86

3.33%

3/26/2015

  17,678.23

-449.42

-2.48%

3/26/2015

    2,056.15

-51.95

-2.46%

3/30/2015

  17,976.31

298.08

1.69%

3/30/2015

    2,086.24

30.09

1.46%

3/31/2015

  17,776.12

-200.19

-1.11%

3/31/2015

    2,067.89

-18.35

-0.88%

 
 The table helps illustrate the dangers of a market timing strategy.  There were several moments during the quarter where these indices experienced 2% to 3% dips but quickly rebounded.  An impulsive investor who lets their emotions dictate investment strategy might easily abandon the stock market during these periods of volatility.  Brief spurts of positive and negative movements in the market are common, but jumping in and out of the market based on short-term performance is not part of a successful long-term investment strategy.

Over a longer period, a market timing strategy can be harmful to your overall wealth by missing out on periods of exceptional returns.  While the appeal of market timing is fairly obvious, (improving portfolio returns by avoiding periods of poor performance) timing the market consistently is extremely difficult.  As an example, look at the period of returns for the S&P 500 Index during the years 1995-2014.  If an investor stayed fully invested for all 5,040 trading days, they would have received a compound annual return of 9.9%.  However, that same investment would have returned 6.1% had it missed only the 10 best days of stock returns.  Missing the best 20 days would have returned 3.6%.  Missing the 30 best days would have returned 1.5%.  Finally, missing the 50 best days out of 5,040 would have produced a loss of 2.2%.[2]

As I have often stated, our investment philosophy remains based on the fundamentals.  The day-to-day price volatility of the stock market is unavoidable and can be deeply influenced by domestic and international variables.  Investors need to manage their expectations of the stock market accordingly.  We believe it is time---not timing---that matters most.   History shows the successful long-term investor is patient, weathers market swings, and adheres to a disciplined investment process that includes a diversified asset allocation strategy based upon a tolerance for risk and need for return. In other words: Don’t use your emotions to make investment decisions; separate your money from your moods.

With kindest personal regards, I am

Very truly yours, 

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.



[1]Source: Principia® Presentation and Education, 2014 Principals of Investing Module, The Cost of Market Timing, Risk of missing the best days in the market 1995–2014.

[2]Source: Federal Reserve System.  FOMC statement Press Release. 18 March 2015. http://www.federalreserve.gov/newsevents/press/monetary/20150318a.htm

 

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