One can argue to what extent the Federal Reserve’s stimulus program has driven economic growth
over the past six years, but it’s inarguable their consistent infusions of liquidity served to reduce
investors’ perception of investment risk. So maybe it’s no accident the ending of their most recent
round of stimulus coincided with a significant pickup in previously dormant volatility during the
fourth quarter. We were accidentally prescient in our third-quarter letter when we hinted that
October is often a cruel month for stocks, as the S&P 500 violently and indiscriminately coughed up
9% over a 19-day period. By early December, the market had soared 13+% to new highs in Vshaped, parabolic fashion, the likes of which we rarely see without some “backing and filling” along
the way. Trying to assign a cause is a pointless exercise – you don’t get extra points for knowing in
hindsight why a market dove or soared. However, it seems that comforting fundamentals –
specifically solid third-quarter earnings reports, improving domestic economic data, and benign
inflation readings – trumped more transitory concerns such as the spread of Ebola and geopolitical
flash fires.
In their late-fourth-quarter open market commentary, the Fed replaced language that it will be “a
considerable time” before they raise rates by saying they can now afford to be “patient.” Even
though their plan to raise rates is still in place, lackluster wage growth, a strong U.S. dollar that
deflates the cost of imports, falling commodity prices and lower interest rates overseas all reduce
pressure on the Fed to act anytime soon. In fact, the futures markets pushed out expectations for
the first rate hike until late next year, allowing the Fed to remain ostensibly accommodative even as
quantitative easing is withdrawn. The market began 2014 with forward (next 12 months) price-toearnings multiples stretched above five- and 10-year averages – levels historically suggestive of
subdued equity returns for the coming year. However, the combination of falling interest rates and
inflation expectations allowed the price-to-earnings multiple for the S&P 500 as a whole to drift
from 15 up to roughly 17 by quarter-end. As a result, the index posted a 2014 return in excess of the
6–8% many expected at the beginning of the year based upon earnings growth alone.
We’re generally very pleased with the progress in our portfolios in what was a more challenging
environment than what headline indices suggested. 2014was another year of divergent performance
– not so much stocks from bonds, as we witnessed in 2013, but because most international markets
and small capitalization stocks significantly underperformed the large stock-laden U.S. indices.
Benchmarking to a single index in isolation can easily distort relative performance positively or
negatively. Since the majority of investors (even if diversified across multiple asset classes and
sectors) tend to compare their portfolios to the S&P 500, we guess they may be disappointed with
their results, given that the S&P 500 ended up one of the top-performing indices in the world.
Fortunately, we deliberately over-weighted large, U.S-centric names in our equity portfolios and were
thus well-correlated with strong S&P returns both in the fourth quarter and for the year.
As value investors, small caps scared us 12 months ago, trading nearly twice the multiple of large
caps with roughly the same growth rates. Some foreign markets looked cheap, but we found it hard
to be confident given that economic data from Japan and Europe (for example) suggested imminent
or at least pending recession. We’re monitoring the still-deteriorating conditions in those economies
and others for promising opportunities, as underperformance may have left them more attractive on
a valuation basis. What’s more, considering our own experience here in the States, we’d be foolish to
not take notice of foreign central banks seemingly committed to doing whatever it takes to right
their economies.
2014 provided more evidence that economic forecasting is often no more reliable than astrology. In
January, analysts surveyed by Bloomberg predicted the 10-year Treasury yield would rise to 3.44%
by year-end. Given that the yield actually closed under 2.2%, it certainly paid not to follow herd
thinking, nor to overreact to last year’s generally negative environment for fixed income. Our
portfolios largely benefitted from a healthy weighting in investment-grade bonds in 2014, a
weighting that we’ve mostly maintained despite market volatility over the past few years. The
demand for U.S. dollar-denominated paper gathered steam in the fourth quarter as the greenback’s
strength in the face of concerning economic data from both developed and emerging economies
overseas attracted a “flight to quality.” Those who sought to enhance fixed income returns by
overweighting high-yield bonds, senior loans and master limited partnerships likely underperformed
the broad fixed income benchmarks – fortunately, we reduced our exposure significantly to these
sectors over the course of the year. In hindsight, we could have earned a bit more return by not
keeping our bond maturities mostly in the short to intermediate range, as longer-term bonds benefit
the greatest in a falling interest-rate environment. We also had little exposure on the equity side to
interest-rate sensitive sectors like utilities and real estate investment trusts, which performed much
better than consensus expectations. However, with value investing, it’s often better to be early than
late, and we’d rather be positioned defensively given what looks to be a challenging environment for
fixed income going forward.
That oil prices had ended 2014 at a 5½-year low and suffered their second-biggest annual decline on
record was a central story in the fourth quarter. Oil prices are no less indicative of global economic
health than inflation or interest rates, and investors had a tough time trying to determine whether
their meltdown was a positive or a negative. Excess supplies largely attributable to the unbridled
success of our own domestic production can be tempered over time, which eventually will lead to
equilibrium and price stabilization. In the meantime, the resulting fall in gasoline and fuel costs
created a gigantic net tailwind for global consumers (both individuals and businesses), even as we
recognize that the U.S. Energy sector’s spending and hiring have been significant contributors to our
own economic recovery.
However, the International Monetary Fund estimates that 20–35% of falling prices has been
attributable to an ebbing global demand. An additional catalyst for volatility in the fourth quarter
was investors’ acknowledging both the positive impact of declining oil prices and the potential for a
deflationary cycle of falling demand, falling prices and destabilized oil-dependent currencies and
economies overseas. We tend to fall in the former camp, yet remain cautiously positioned. Not only
are our equity portfolios underweight in Energy relative to its participation in the S&P 500, but
we’re confident we hold some of the highest-quality names. These are companies whose balance
sheets should be able to weather the storm and are positioned to increase market share if not
additional assets through acquisition.
Outside of U.S. Energy stocks, our portfolios continue to be light in the areas most sensitive to a
treacherous investing environment, including emerging market debt and equities, high-yield bonds
and commodities in general.
As always, we will seek opportunities when the risk-reward trade-off balance tilts more in our favor.
Just recently, for example, we took on some back-door exposure to the Energy sector with a modest
position in a high-quality yet recently depressed engineering and construction company with longterm leverage to Energy infrastructure spending.
Regardless of how the markets play out, we think that in the context of a generally favorable
investment backdrop, most assuredly higher levels of volatility are here to stay in 2015. Increasing
volatility demands great investor discipline, not only in terms of maintaining the proper asset
allocation, but also in terms of selectivity and attention to valuation. As always, we’ll do our best to
be your faithful stewards, and we greatly appreciate your continued trust and confidence!
Best regards,
The Wise Investor Group
Robert W. Baird & Co. Incorporated.
866-758-9473 thewiseinvestorgroup.com
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