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April 2015
A Ride to Nowhere
Review of Markets
2015 began with the S&P 500 at 2058.9. To
some extent, the first quarter of 2015 reminded
me of the first quarter of 2014. The stock market
began its slide throughout January. It bottomed
on January 29th at 1995, and then proceeded to
fluctuate in a fairly narrow range, peaking on
March 1 at 2117. The quarter closed with the
S&P 500 at 2067.9, up 0.4%.
The action of the DJIA and the S&P 500
represented the larger stocks in the market. It
did not represent other investment elements. If
you owned small stocks, bonds, real estate,
special investments, such as technology, and
were broadly diversified, you likely did much
better. The quarter was the “poster child” for
why diversification is so important.
The narrow trading range of the stock market
has come as investors look to the potential for
growth in the U.S. and international markets.
The outlook is not as robust as it appeared
during the fourth quarter of 2014.
Languishing Economic Recovery
A number of factors are coming into play as the
economy moves forward. While businesses
began to hire more employees and believed in
the idea of a growing economy during 2014, the
resistance of consumers to buying goods and
services has surprised them. The consumer
drives about 67% of the U.S. economy. The
consumer’s resistance to increased credit card
debt and general spending is holding the
economy back. As businesses added to their
expenses, with the acquisition of new
employees, increased technology spending, and
expanded physical facilities, their overhead
went up. This increase in overhead seemed like
a good idea, as long as the economy continued
to expand, since sales would increase and profits
grow. With the lack of consumer spending,
overall corporate spending went down in the
first quarter. The lack of spending brought a
downturn in business revenue. Lower revenue
was more evident in those businesses that added
to their expenses with expansion. An increase in
expenses, without a concomitant expansion of
revenue, results in lower productivity.
Ultimately, such conditions reduce profits,
making stocks less desirable.
Inflation Impact
Inflation is an important factor in the economy.
Too much inflation is not good. Too little
inflation is not good. In looking at inflation for
the first quarter, we notice something rather
disturbing. While the final numbers have not yet
been released, it appears the core consumer rate,
which excludes food and energy, will rise in
March about the same as in February, 1.4%. A
big piece of the core inflation rate is consumer
housing. This number is basically taken from
the cost of apartment rentals across the U.S.
Rents were up over the prior year about 3.5% in
March. We are seeing a shortage of rental
apartments. The vacancy rate at the end of 2014
stood at 7% and has likely diminished further. It
is difficult to determine the cost of housing for
private residences, therefore the labor
department uses rental rates to determine what
housing costs might be for individuals who own
their own homes. Without the rental rate
component, in determining the core inflation
rate, the rate would have been 1%.
Concern in the FED
The estimated inflation rate of 1.4% is too low.
The FED would like inflation to run between
2% to 3%, in order to keep the economy
expanding. An adjusted rate of 1% (taking out
the rental component) leaves a real possibility of
the economy going into deflation. Once
deflation gets started, it’s hard to turn around.
In the 4th quarter of 2014, the economy grew by
about 5%. This was a very strong growth rate. It
seemed likely at that time that the FED would
increase short-term interest rates by early
summer to cool down the expansion. The
current languid growth makes it now appear that
the FED will take no such action. An increase in
short-term interest rates would likely slow the
economy even more and could push it into
deflation.
In a deflationary environment, consumers tend
to slow spending to a crawl. Because prices are
going down, buying something now has no
impetus since it will be cheaper later. In such an
environment, businesses will also defer
spending because the cost of goods and services
are dropping. This reduces their revenue,
reduces productivity, and reduces profits. These
concerns have motivated Europe to make many
of the changes to their monetary thinking since
last year, when they faced a situation similar to
the U.S.’s current position.
Where We Stand Currently
Since 2009, the U.S. economy has been in a
very slow recovery. The stock market has
experienced several very good years, and in my
estimation, prices on stocks may have risen
higher than normal, given earnings and earnings
potential. We have not had a significant
correction in the stock market in more than five
years. This is unusual. To some degree, the slow
growth has impacted consumers, as they have
not seen a rapid rise in job availability, increases
in net take-home pay and a feeling of security in
jobs or community. With unrest and concerns in
other parts of the world, investment funds are
flowing into the U.S. at a high rate. This has
made the dollar stronger and made the cost of
U.S. goods and services more expensive
internationally. As I indicated in my January
Newsletter, we want to see growth and
improvement in Europe, as soon as possible.
Recent studies seem to indicate that China, a
growth engine for many years, is only growing
at a 4% to 4.5% rate at this time.
Conclusion
The U.S., with all of its issues, is still the most
stable country in the world. Going forward, we
will likely continue to see investment
opportunities in some key areas of the economy.
During much of the recovery, medium and
smaller stocks have not performed as well as
their larger counterparts. We are seeing a
change in this area. The demand for commercial
real estate still seems strong and the long-term
prospects for natural gas look good.
Technology, which is a big component of U.S.
growth, also looks good. For stability,
intermediate bonds appear to hold significant
value. The answer, therefore, as always, is
diversify, diversify, diversify!
Ed Mallon