January, 2015
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

My wife received the following puzzle this year as a Christmas gift:

Putting it together brought feelings of nostalgia as the iconic images took shape. Many of the pictures brought instant recognition and a remembrance of the story behind it, though some required a Google search to discover its significance (I did so, and found answers at the following link address: http://www.whitemountainpuzzles.com/ the_eighties_puzzle_key.asp).

As we look back at the events of 2014, I wonder which, if any, of these events will turn out to be significant enough to land on a 2010’s puzzle in 30 years.

  • Implementation of the Affordable Care Act
  • Legalization of Marijuana
  • Janet Yellen takes over as chair of the Federal Reserve
  • GM recalls
  • Robin Williams passes
  • Malaysian Airlines Flight 370 disappears
  • Germany wins soccer’s World Cup
  • Winter Olympics in Russia
  • Islamic State in Iraq & Syria (ISIS) decapitates US journalists
  • Republicans control Congress after Midterm elections
  • Ferguson protests
  • Ebola outbreaks

From an investment standpoint, 2014 was a good year if you were invested in U.S. based assets, with the S&P 500 gaining 13.7%, continuing a remarkable 6 year run. This was only the 9th time since the mid 1920’s that the index has had double digit returns for 3 straight years. The biggest surprise was the returns produced by long term bonds, basically doubling that of the S&P 500; this from an asset class investors were predominantly told to avoid at the start of the year.

Index 4th Qtr
2014 Return
1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 4.9% 13.7% 20.4% 15.5%
Dow Jones Industrial Average 5.2% 10% 16.3% 14.2%
Nasdaq Composite 5.7% 14.8% 23.6% 17.2%
Russell 2000 – Smaller Companies 9.7% 4.9% 19.2% 15.6%
MSCI EAFE – International -3.6% -4.9% 11.1% 5.3%
Barclays US Aggregate Bond 1.8% 6% 2.7% 4.5%

You may have noticed the divergence in returns between foreign investments and those based in the U.S. The two main reasons for this are that the domestic economy has been growing faster than most of the rest of the world and as we highlighted in last quarter’s letter, the U.S. dollar has risen strongly compared with other currencies. This causes investments made in foreign markets to lose value when they are measured in dollars.

Here’s an example of how that works – suppose you invested $5000 in European stocks through a diversified mutual fund. That fund manager will convert your dollars to euros to purchase the stocks. Earlier this year, at an exchange rate of $1.35 per euro, your $5000 would result in 3703 euros to invest. Your investment did moderately well throughout the year and gained 7% and your 3703 euros are now worth 3963 euros. The problem comes when you (or the fund on your behalf) converts those euros back into dollars. The dollar has increased in value so that a euro now only cost $1.19, which means your 3963 euros are only worth $4716. Your overall investment has decreased in value by 5.7% even though your stocks went up – this is the power of a dramatic change in currency rates.

Probably the most talked about development in the fourth quarter has been the precipitous drop in the price of oil. This drop, from around $100 a barrel as summer began to around $50 today, has provided a welcomed respite at the gas pump but has created some challenges for investments related to the energy sector. The following 2 charts tell the story - the first one showing the effect, the second one showing the cause.

The drop in oil prices has been much more of a supply issue than a demand issue. There has been an increase in worldwide supply brought about primarily by increased production in the U.S. However, the change in supply has not been proportional to the change in the price of the commodity, leading us to believe that prices at this level are not necessarily here to stay for the long term. But in the meantime, the extra money that people are not spending on gas will likely lead to growth in other consumer spending.

So what are we to expect in 2015? Consensus estimates say the economy will grow at a about a 3% rate, the Fed will start raising rates in the summer and continue throughout the second half of the year, the S&P 500 will return about 5%, the 10 yr Treasury bond yield will grow from 2% currently to about 3.2%, unemployment will continue to fall, the dollar will continue to rise, and inflation will come in at 2%. The problem is that the consensus is rarely correct; for instance this time last year, conventional wisdom said to avoid long term bonds and expect good returns from global equities. And so we favor an investment philosophy that incorporates diversification and leaves room to expect the unexpected. A quote I heard recently said “Allocate based on the probability, but diversify based on the possibility.”

This diversified strategy allows for us to implement some tactical ideas where we feel they are appropriate. Because we believe the current level of the price of oil is not here to stay, we favor making some investments in the energy sector. While we do want to have some of our allocation devoted to the international markets, we do think it is prudent at this time to reduce some of our investments that are non-dollar denominated. Even though the overall market valuations are becoming high, we have still been able to find individual stocks that we like that have compelling valuations.

Speaking of the market’s valuations, the following chart shows various valuation measures of the S&P 500. As you can see, the current valuations now exceed their historical averages.

This does not mean that good returns cannot be had in the stock market; the markets just aren’t as cheap as they used to be. We should also be reminded that double digit returns do not come every year and it is likely that there are more years behind us since our last recession than lay ahead of us before the next one, and so diligence is required.

I’m occasionally asked what books I’m reading or if I have any recommendations. While I am making my way through a biography of every U.S. President (just finished #6 John Quincy Adams), the best book I read this year was a fictional novel called “The Martian” by Andy Weir. Full of math and science and suspense, though it does contain PG-13 language, it gets my recommendation.

I guess letters to Santa have come a long way since those nostalgic days I referenced at the beginning of this letter:

Thanks to all of our clients and friends for a great 2014. We look forward to another great year.

Sincerely,
The Castle Investment Advisors®, LLC Investment Team

                    
 
Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.