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

Remember back to your high school algebra class when you were given the task of manipulating variables? The progression usually went something like this:

4 * x = 4x Piece of cake
3(9x) = 27x No problem
2(3x-5) = 6x-10 A couple easy calculations
(6x+2)(4x-7) = What in the world am I supposed to do with that?!

Then your teacher diligently explained the solution process and even gave you a nice acronym to help you remember what to do – the FOIL method, which taught you to multiply the terms in the following way: First – Outside – Inside – Last.

Many people look at the economic world today with the same amount of confusion as they did when they were first presented with the challenge of multiplying binomials. Fortunately we can use the same FOIL acronym to narrow the issues down to the top 4 that are most impacting the economy today. Our FOIL will stand for: Fed – Oil – International – Labor

F – The Federal Reserve

The Fed has kept interest rates at or near zero for quite some time and now as the economy has slowly recovered from the crisis of 2008, the question has become when the Fed will begin to raise rates. The follow up question is similar - once they start raising rates, how quickly and how frequently will they continue to raise as they head back to a more normalized level.

While there is some belief that they will initiate the first rate hike at their meeting in June, it seems most likely at this point that the process will begin in September, though of course one can never predict this with much certainty, and there are some who don’t see it happening prior to December. As for the pace of tightening, most observers seem to expect the Fed to increase rates a quarter of a percentage point every other meeting through 2016 and then gradually increase the frequency in 2017.

How will the stock market react when the Fed starts to move? Historically what we have seen is that markets drop in value in the early stages of the raising process, but a recovery ensues as the process continues and markets end up higher at the end of the rate hike period than they were when it began. Here’s a look at the performance of the S&P 500 during last 3 rate raising cycles:

All charts courtesy of J.P. Morgan

O – Oil Prices

The drop in oil prices continues. While this provides challenges to oil producing companies, it does provide a boost to the U. S. economy; economists estimate this boost to be an addition of about 1% to GDP. Gas prices ended the quarter at an average of $2.46, which is up from the year end price of $2.30 but still down considerably from the $3.27 we were paying at the end of 2013; saving the average family about $550 last year according to AAA.

Some are predicting that a finalization of a deal with Iran could put more oil supply in the worldwide market and continue to put downward pressure on prices but most experts see that as a temporary event without much long term effect. Whatever direction oil takes from here is anybody’s guess but energy costs continue to be a big component of the global economy.

I – International

The particular focus here is in regards to currency. The U.S. Dollar has risen dramatically in the past 6 months, about 20%. While a general direction of the move was not surprising, the pace and the magnitude caught many market participants off guard.

While the tendency is to champion a strong dollar as a source of national pride, the reality is that every 10% rise in the Dollar brings about a 1% drag on GDP growth. So with a 20% rise, you can see that the drag on the economy from the rising dollar is greater than the boost it received from lower oil prices.

Similar to the story with Iran and oil prices, a deal struck with Greece has the potential to temporarily push the Euro higher.

L - Labor

The story on the labor front has been the combination of a steady drop in the unemployment rate – down now to 5.5% - with wage growth that has been slow to respond. This lack of wage growth has been one of the contributing factors to the Fed waiting as long as they have to begin raising rates.

Bringing it all together

With these 4 main factors as a back drop, what do we expect? It is likely that economic growth will be slower than we had hoped but still positive and that earnings for many companies will be lower in 2015 than they were in 2014. Does this mean it is time to avoid equities, especially considering that we are now in the 7th year of a bull market? We don’t think so. If we were about to experience a big market selloff, we would expect to see one or more of the following:

  • An economy that is entering or is in a recession
    • While there are a few discouraging data points, there are plenty of positive ones as well
  • An aggressive Federal Reserve
    • This Board is showing itself to be very patient and cautious
  • Extreme market valuations
    • While valuations are above their historical averages, they are not at extremely high levels. The chart below shows the Forward P/E at a level that is about 0.5 standard deviations above the historical average.

So the markets are up, can they go higher? Yes. Are they due for a correction? Yes. What should investors do? Diversify.

The chart on the next page shows how one form of diversification (we believe true diversification involves more than just stocks and bonds) has played out over the most recent market cycle. Using a market peak in October, 2007 as a starting point, the 2 diversified portfolios (compared to the S&P 500) provided some protection during the bear market and allowed the portfolio to more quickly recover losses when the stock market turned bullish. Now following 6 years of the market moving higher, all 3 portfolios would be worth about the same amount.

Diversification has been described as an investors best friend on their worst day and we believe in its value for most portfolios.

We will wrap up this newsletter with a brief recap of the first quarter. The quarter felt more volatile as the DJIA moved triple digits on more than half of the trading days and there were 20 days when the markets moved either up or down more than 1%. This was the most in a quarter since Q4 2011. But at the end of the quarter, large Company U.S. stocks had changed little, posting a small gain with the Health Care sector leading the way. Last years best sector, utilities, turned in the worst performance this quarter, losing 6%. Meanwhile international stocks bounced back somewhat from last year’s struggles, gaining almost 5%, with smaller sized companies also having a good quarter and commodities continued their decline.

Index 1st Qtr
2015 Return
1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 0.95% 12.7% 16.1 14.5%
Dow Jones Industrial Average 0.3% 10.6% 13.2% 13.2%
Nasdaq Composite 3.8% 18.1% 18.1% 16.7%
Russell 2000 – Smaller Companies 4.3% 8.2% 16.3% 14.6%
MSCI EAFE – International 4.9% -0.9% 9% 6.2%
Barclays US Aggregate Bond 1.6% 5.7% 3.1% 4.4%

Mergers and acquisitions were active with the most prominent being the announcement of a merger of Heinz with Kraft.

In index news, Apple was added to the Dow Jones Industrials, replacing AT&T, while American Airlines was added to the S&P 500.

Thanks for reading. We at Castle wish you a happy and healthy spring.

                    
 
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.