“Everything is Awesome!!!” is the theme song of the Lego Movie. It is a good theme song title for U.S. equity investors in 2014. The fourth quarter concluded with the S&P 500 returning 13.7% for the year (4.9% in the fourth quarter alone). This is even more impressive considering a violent downdraft after Thanksgiving. Almost all major market indexes are at record all-time highs. Small Cap U.S. stocks, while still slightly trailing large cap for the year, returned an impressive 9.4% in the fourth quarter. Since bottoming in March of 2009, the S&P 500 has posted a 246% total return.
Image Courtesy: http://lego.wikia.com/
While the economic recovery has been painfully slow for a large number of Americans, confidence may finally be returning. Estimated GDP growth of 4.6% in the third quarter was well above expectations. For the first time since 2007, the 11/28/2014 CNN poll showed a majority of Americans (albeit 52%) viewing the economy as improving over the next year.
Influencing Economic Factors
So what have been the building blocks of this ‘Awesome-ness’?
- Job creation has accelerated and unemployment has fallen to 5.8%.
- Household fiscal conservatism in reaction to recent experience has radically improved the consumer balance sheet. Household debt levels have fallen by $1 trillion, average household net worth has increased by 35% since the depth of the recession and real estate equity has risen by 50%.
- Pay levels are improving both due to economic activity and Baby Boom Generation retirements. The impact of lower fuel prices has created room in corporate profit margins to allow higher wages.
- Inflation continues to be low to non-existent. Booming U.S. oil, gas and wind power production, falling commodity prices and production efficiency has kept the cap on prices and corporate profit margins flush. Gasoline prices have fallen below $1.80 per gallon in many areas. This represents a major fiscal stimulus for the consumer.
- The U.S. Federal Government deficit is down from its high watermark of $1.2 Trillion in 2009 to $500 billion in 2014. All of the major emergency bank and corporate bail-outs have now been repaid to the Treasury. In aggregate, they yielded a small gain. The projected solvency of the Medicare System increased by 14 years on account of higher tax receipts.
- Interest rates have remained low. The Barclays Aggregate Bond Index had a total return of 1.9% for the quarter and 6.0% for the year. Even at current low levels, interest rates in the U.S. are higher than in almost all of the rest of the world. The U.S. Federal Reserve finally ended Quantitative Easing in October.
- The head of the U.S. Federal Reserve remains committed to very low rates until the economic recovery is both strong and broad, including the prospects of the middle and lower classes. Making the Fed’s role more complex, (likely slower and more muted) is the fact that any rise in interest rates will be at cross purposes with Asian and European Central Banks who are lowering rates. Europe is teetering on either side of recession and China’s growth is continuing to slow to well below target. Rising rates in the U.S. could also present an economic head wind as it would lead to a rising dollar hurting exports. The Fed will be wrestling with the conundrum of doing right thing for the U.S. vs. doing the right thing for the world.
Why Cautious Counsel Is Still Required
While the equity investment picture may be improving, not all caution should be thrown to the wind.
- The rapid collapse of oil prices while a net positive for the U.S., also has been so quick and violent that it might lead to economic dislocations ranging from damage to the economies of oil producing countries and their creditors, to the potential bankruptcy of highly leveraged domestic oil producers and to the curtailment of U.S. domestic drilling and exploration expenditures (which have represented 40% of all business capital expenditures over the last five years)
- Housing activity in the U.S. continues to be weak. This reflects constrained lending based on regulatory issues, a new consumer conservativism and pessimism concerning economic opportunity.
- While the U.S. economy is more self-contained than the economies in the rest of the world, none-the-less exports have contributed handily to economic growth over the last decade. Continued weakness in Europe and in China could be a drag on growth. Brazil’s economic future is also clouded. While China’s government appears to be taking a very measured approach to slowing its economy, it is a very tender operation given the highly leveraged nature of its financial system and lack of accounting transparency. Recent issues at Walmart’s subsidiary in China refreshed concerns over the quality of Chinese accounting standards.
- While the typical signs of a bubble, including small retail investor activity, have not been present in the U.S. equity markets, U.S. equity valuations are no longer cheap. Many issues are priced to reflect perfect results in terms of growth and margins. While the long-term picture remains favorable, current valuations do make the market vulnerable and volatile.
Despite the cautions, we feel that like Lego blocks, the building blocks of the economic recovery are now durably interlocked.
As the New Year progresses, you can follow our strategy via our website www.CarnegieInvest.com. Let’s discuss your own equity investment strategy for 2015, and work toward another “awesome” year together:Speak to an Advisor