Tuesday, January 6, 2015

Lower Gas Prices – Unequivocally Good for America

From the Desk of Joe Rollins

We just closed out another spectacular year from a financial standpoint, and the financial news continues to be good for all of America. The price of oil today is roughly 50% of what it was at the beginning of the year. There is much made of this decline in oil, that maybe this is a foretelling of the economy slowing down. I think exactly the opposite is true. While certainly 8% of the US population will be impacted that earns a living drilling and selling oil, the other 92% are direct benefactors and that cannot be anything other than unequivocally good for America.

Before I get to more interesting topics, I will give a complete summary of the year just ended. The month of December was pretty much a negative month, where virtually all asset classes lost money. Had it not been for the last two trading days losses, the month would have been up marginally. However, with the sharp sell-off at the end of the year, virtually all the indexes turned negative. Especially hard hit were high yield bonds, which took a very large move down with the concern that energy related high yield bonds would affect the whole asset class.

For the year 2014, the Standard and Poor’s Index of 500 stocks was up 13.7%. The Dow Jones Industrial Average was up 10.1% and the NASDAQ Composite was up 14.8%. I have previously written about how difficult a time the Russell 2000 small cap stocks had in 2014, but they actually had a decent month in December and ended the year up 4.9%. We would expect that small cap stocks should rally in 2015, but then again we thought so in 2014 as well. As appropriate, the Barclays Aggregate Bond Index was up 5.9% for the year, which is actually lower than would be expected given that long-term rates were moving down throughout the year.

Although many people thought 2014 was volatile in its trading, actually the opposite was true. We did not have a 10% correction at any time during 2014. We had some sharp sell-offs in July, October, and December, but none of them actually reached 10%. We saw a lot in the financial media about the upcoming crash, however there was no financial support for any type of severe correction, and in fact we never got one. What was even more interesting was that the S&P 500 did not have 4 consecutive down days at any time during 2014. In the history of finance, that is the first year that has ever happened.

Historically, the third year of a presidential term is pretty good. There are a lot of reasons for that strange financial fact, but principally it is due to everyone trying to please the taxpayers based upon the upcoming election in the fourth presidential year. Given the gridlock we have in Washington with a Republican Congress and a Democratic presidency, there is a high likelihood we will have complete gridlock in Washington, which is always good for stocks. When Congress is demobilized, it is more often good for stocks than not.

One strange financial fact is that no year ending in “5” has delivered a negative return since 1885 (130 years ago). No one seems to know why, but I suspect it has to do with the presidential cycle. In fact, going back all the way back to 1885, the average gain in the year ending in “5” was 23.8%. However, we do not invest money based upon theories, graphs, or which way the moon is shining. We only invest money based upon economic understandings and economic effects on corporate earnings. Today all of those are positive and look good for 2015.

We just closed the year with the S&P earning a very outstanding return of 13.65% for the year. When you couple that with the fact that the S&P has now been up for six straight years, the numbers are nothing short of spectacular. Study the following chart:

I wish I could tell you how many clients I talk to on a weekly basis that sold everything in 2008 and never have reinvested. Yes, it is true the S&P lost 37% in 2008; however, as the above chart indicates, this amount was quickly made up and far surpassed in the last six years. I wrote a blog on November 18, 2014 that indicated that more money has been lost trying to avoid market crashes than ever has been lost in the actual crashes (“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch). As the above chart indicates, the only people that lost money in 2008 were the people that sold out and never actually reinvested. Hopefully, you are not one of them!

I direct your attention back to the blog I wrote on January 14, 2014 (I Was Wrong, But In A Good Way...). I start most years with a projection as to what I believe the year might bring, from a financial standpoint, and will do so later in this posting. You will note from that posting that my direct quote last year was,
“Therefore, my projection for 2014 is that the broad market will go up roughly 12% – 14%, which would be a spectacular year, given that the S&P was up 16% in 2012, 32% in 2013, and my projected 13% for 2014.”

As you can tell, the actual return of 13.65% was at the high-end of my projection for 2014. What is even more interesting is that the market sold off roughly 1.5% in the last two trading days of the year, which prevented us from actually far exceeding the projection that I made this time last year.

There are a lot of interesting financial events going on, which I will discuss later. However, I wanted to emphasize the projection for 2015 and give you some sort of idea of my thinking. Once again, if you reference the January 2014 blog, I predicted that the S&P projected earnings would be greater than $118 and I was correct. In fact, I projected a 5% increase from the Standard & Poor’s earnings analysis to a level of $124. Interestingly, through November the actual earnings for 2014 were $126.79 and even my projection ended up being low. I suspect after the December numbers come in, the amount might be even a few cents higher than that amount.

When you project earnings into the future, it is always a precarious situation. There are just so many moving parts to the American economy that it is hard for any one component to affect earnings in a meaningful way. However, the decline in gasoline is one that, in my opinion, will clearly improve earnings. Virtually every industry in America is impacted by gasoline prices.

Not only the companies that produce products that use petroleum as a byproduct, but also the transportation of goods by trucks, etc. Not only will the reduced price of gasoline increase earnings for these companies, it also will give Americans more disposable income to spend. In my opinion, the dual effect of reduced petroleum costs and more expendable income by the public will greatly enhance earnings going forward.

I checked the Standard & Poor’s website today and their projection for earnings for 2015 is $131.14. Once again, I think that number is too low, due to a lower oil cost, and therefore I will increase it by 4% to $136.39. The most important component of stock prices is earnings, but interest rate additionally will affect potential earnings. I think there is absolutely no question that interest rates will go up in 2015, and therefore project a lower multiple of earnings in 2015 than I have previously used.

The long-term average for earnings is 18.7 X projected earnings. Currently, the market is selling at roughly 15.5 X projected earnings, which still undervalues the market slightly. I think realistically, the projected earnings will go up to a multiple of 16.5 X, which is not as high as I projected in prior years. Often times, I use a multiple of 17 X, but I think there is a possibility that interest rates would become a factor during 2015 and draw some money out of equities.

If you use projected earnings of $136.39 and a multiple of 16.5 you should end 2015 with an S&P value of 2250. The S&P closed at the end of the year at 2059 which would indicate that the index would rise 191 points during 2015.

Therefore, I project that the S&P will be up 191 points to a level of 2250 at the end of 2015. That gain would constitute a 9.2% gain and when you add the 2.5% dividend yield of the S&P, you have a calculated gain of 11.7% for 2015. Therefore, it is my projection that even though we have enjoyed six straight years of excellent earnings on the S&P 500 index, I project that once again in 2015, the increase in value should be from 10% to 12% on total return basis.

The one projection that I clearly missed was that I projected interest rates would go up for 2014. Fortunately, everyone else missed this one also. Very interestingly, interest rates actually went down in 2014. The year started with a 10-Year Treasury at roughly 3.9%. As 2014 has ended, the 10-year Treasury has dropped to rock-bottom, roughly 2.2%. Virtually no economist projected this decline in interest rates during 2014.

I think one of the interesting aspects of interest rates is that during most of 2014, the federal treasury bought bonds on an enormous scale. Many of us did not think that these purchases would have such a dramatic effect on interest rates. However, clearly, they must have as I see no other explanation for rates falling in a year when projected inflation is 1.75%.

The other aspect of interest rates is that the rest of the world continues to cut interest rates to try to stimulate growth. The 10 year treasury has an exact yielding at the end of the year at 2.1703%. Compare that with the German 10-Year Treasury, which is currently yielding 0.54% and the Japanese 10-Year Treasury yelling 0.33%.

Would you rather invest your money in the German economy at one half of 1% for 10 years or the Japanese economy at one third of 1% for 10 years? In Germany, the two year rate is now negative – you have to pay the government to take your money for two years. This dramatic decline in interest rates around the world has led to a rapid increase in the value of the U.S. dollar throughout the world. It only makes sense that investors would bring their money to where it is treated best. Clearly, investors from around the world are coming to the U.S. to invest in bonds, yielding 4 or 5 times the bonds of their own country.

The strengthening of the dollar is a very good economic indicator of the strength of the U.S. economy. Clearly, the U.S. dollar is the currency of choice throughout the world. While it is true that higher dollars make exporting more expensive, this is the nature of a competitive economy. I fully expect to see economies around the world strengthened in 2015, but that does not mean the US economy is any less strong. Once again, the U.S. economy leads all countries except China at the current time in GDP growth, and I am not sure anyone believes China’s economic numbers. However, I clearly think that 2015 will bring a slight recovery to Europe, South America, and the economies of other developed countries.

From an economic standpoint, we are really in a sweet spot for the economy and for higher stock prices. As pointed out many times, the value of stocks increase when the economy is good, interest rates are low, and earnings are growing; we now have all 3 of those components. The rate of inflation has dropped to 1.3% due to reduced gasoline prices. Manufacturing continues to grow and now capacity utilization is up to 80%, which in economic terms is referred to as full capacity. More importantly for stock prices, personal income is up 4% and the unemployment rate continues to drop. The unemployment rate has improved 17% over the last year, with almost 3 million people now at work that were not there a year ago. A big component of consumer spending is consumer confidence, which is at 92.6%, an almost 20% increase from last year. There is no question that the economy is good, and even if interest rates float up, it should not impact stocks in a dramatic way.

Also, do not underestimate the potential buying power that the reduction in gasoline prices will have on the economy. According to the U.S. Transportation Department, there are 250 million registered vehicles in the United States. If the savings on gasoline is only $20 per week, the net effect to the economy is a savings of a cool $260 billion. No one for a second believes any of this money will be saved, and therefore this additional spending will surely help the economy in 2015. While it is true Exxon will only make net minimum of $20 billion from $40 billion, I think they will survive.

With the value of the dollar increasing dramatically over the last year, total returns on international funds have been negative. It is hard to make money in the international market when the value of the U.S. dollar is increasing. While I expect that the dollar will continue to float up over the first half of the year, I would expect a stabilization of this rate by mid-year which should bode well for international funds in the second half of 2015. There has been virtually no international growth in values over the last year and a half due to the strengthening dollar. However, a stronger dollar improves the economies by overseas manufacturers and therefore, we should see improving economics in Europe, Asia, and especially China in the coming year. We will be watching the trend closely and will have no hesitation to move to international funds if they start to perform more positively.

In summary, I think 2015 will be an excellent year for stocks. It will not be simple and there will be volatility, but overall the trend will be up. I see a move away from interest sensitive type stocks and certainly bonds. I would not expect that bonds would have a very productive year, but U.S. stocks should perform well; maybe in the second half of the year, the international stocks will contribute. Finally, I cannot mention any other more important topic than gold, which I am questioned about virtually daily. It is hard to believe that people still feel so strongly about gold even though the negative performance continues year after year. The Fidelity Select Gold Fund, a sector fund focused on gold and mining stocks, lost 8.5% in 2014 and is now down for the fourth straight year. Investing in gold is strictly speculative and has little to do with actually investing. I cannot see any allocation of gold for many years to come.

Once again, I would like to mention that the time to invest your IRA money is now. We are in a new year and the best time to create tax deferred income is early in the year. So many times I get the comments “I do not make IRAs because they are not tax deductible.” However, everyone is allowed to make an IRA regardless of whether it is deductible or not. The fact that you can put this money on a tax deferred basis for 10, 20, or 30 years, means everyone should make that contribution. If you have the option of doing a Roth or rolling money from a regular IRA into a Roth, you should never lose that opportunity and you should do it every single year.

Again, we invite you to come in and visit with us and let us understand your goals and let us explain our recommendations. There is so much positive going on that is overshadowed by the problems of the world. As the last few years have indicated, even with all the problems we face on a daily basis, the returns are still extraordinary and if you are not invested, you have missed out on a golden opportunity. It is never too late to invest. As our old friend Jim Kramer on CNBC says, “There is always a bull market somewhere.” If you have uninvested cash, now is the time to become fully invested.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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