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Fourth Quarter 2014 - Pinnacle Investment Management, Inc.

Fourth Quarter 2014

January 2, 2015 / Quarterly Newsletters

US equities had another good year, with the stocks of large companies doing better than mid and small size companies. International stocks were a different story. Although they gained in local currency, weakening foreign currencies produced losses when converted to dollars. After a modest decline in 2013, the US aggregate bond index posted a respectable gain.

Rapidly falling oil prices briefly rattled the global equity markets this fall. Although the markets quickly recovered, the price of oil did not.  Financial markets prefer stability to turmoil and the decline in oil prices along with the strengthening US dollar provided a cause for investor concern. Once investors realized that the decline in oil prices was primarily the result of a plentiful supply rather than a weakening economy they breathed easier and markets recovered.

The economic impact of the decline in oil will not be uniform. Energy exporting countries such as Russia, Iran, Venezuela and Saudi Arabia will suffer from dramatically lower revenue, while net energy importing countries such as the US, China, Japan, India and South Korea will benefit from much lower energy costs. Similarly, companies, industries and geographic regions of the country devoted to energy production will suffer, while airlines and other energy consuming industries will benefit.

The US economy grew at a 5% seasonally adjusted rate in the third quarter, the strongest growth in eleven years. Surprisingly long term interest rates continued to decline, with the interest rate on ten year US Treasury bonds declining from 3.0% at the beginning of the year to 2.2% at year-end. The Federal Reserve’s Quantitative Easing (QE) program ended and the US economy is showing signs of strength, which is causing short term rates to rise.   The yield on two year US Treasuries has risen from 0.38% at the beginning of the year to 0.67% at year end.

Returns for key indexes (including dividends) were:

4th Qtr


Full Year


Dow Jones Industrials 5.2% 9.9%
S&P 500 4.9% 13.6%
NASDAQ 5.4% 13.4%
S&P 400 mid-cap 5.9% 8.2%
Russell 2000 small-cap 9.3% 3.5%
Total International, excluding US 4.4% 4.7%
Dow Jones World Stock 0.1% 2.1%
Barclays Aggregate Bond   Index 1.9% 6.0%


Although US interest rates are low they remain significantly higher than many other countries. This interest rate differential is helping to strengthen the US dollar relative to other currencies. This will benefit US consumers, but is an obstacle to US exporters. It also creates a headwind for US investors who have invested overseas, as the value of their overseas investments depreciates when converted back to US dollars.

Economic and Market Outlook The current economic environment of a growing economy, low oil prices and low interest rates is favorable to stocks. Professor Jeremy Siegel of the University of Pennsylvania believes the fair value of the S&P 500 to be 2300 today, approximately 10% higher than its current level. Even if that level is not achieved for another year that still implies a return of approximately 12% over the next year if dividends are included.

The US stock market has advanced in each of the last six years and it’s been three years since the market corrected 10% or more (it declined 19% in 2011), so it would not be surprising to see a temporary market correction of more than 10% in 2015. Now that we have had six years of market advances, the important question is whether a seventh year is possible. While seven straight years of advances are rare, we did experience eight straight years of advances in the S&P 500 (including dividends) in the 1980’s (1982-1989) and nine years in the 1990’s (1991-1999).

There are two stock market cycles occurring in 2015.   The first has to do with the presidential term. Since 1940, the third year of a presidential term has been positive in each year, with an average gain of 21.1% (but rises to 24.4% for second term presidents). One explanation is that politicians go to great lengths to get themselves and their party re-elected, and take whatever economic medicine is necessary in the first part of their term in order to set the stage for better times in the second half. The second cycle is inexplicable but it is a persistent pattern in the stock market that years ending in “5” have produced positive returns over the last one hundred years. While it would not be prudent to hang our hat on either of these cycles, it may not hurt that they point in a favorable direction.

Foreign economies and markets have not been as fortunate as the US.  Japan and most of Europe are still enduring a slow recovery from the 2008 financial crisis and 2015 economic growth in the European Monetary Union (EMU) is forecast at an anemic 1%. Several countries in Europe are still suffering from extremely high unemployment and a population growing weary of “austerity” is questioning whether they should remain part of the EMU. Greece will hold a national election in late January with one of the leading candidates proposing policies which conceivably may result in that country departing the euro-zone. Such an exit, or even a credible threat of an exit, would create uncertainty and turmoil in the financial markets.

Low interest rates in Europe and Japan will likely keep their currencies weak in relationship to the US dollar and if the Fed increases rates as expected in 2015 that would put further downward pressure on foreign currencies.   As a result of the strengthening dollar, mutual funds that hedge the currency risk have become attractive. In spite of these risks and hurdles, foreign stocks are more attractively valued than US stocks.

Non-defense government spending has grown from 7% of GDP in the 1950’s to 9.6% of GDP in the 1960’s to 17% today. This has occurred even though European experience in the 1970’s showed that more government spending resulted in higher unemployment since additional taxes reduced the amount consumers and businesses had available to spend. Of course the government could merely print money to pay for the spending. Yet if printing money could create jobs or wealth, counterfeiting would be an honored profession.

States with high tax burdens, such as Connecticut and other northeast states, are experiencing a net out-migration while those with a low tax burden are benefiting from a net immigration according to the Tax Foundation. Residents appear to be voting with their feet and the outbound migration is worsening the financial condition in already heavily taxed states since there will be fewer taxpayers left to foot the bill.

Economics may influence foreign policy   Oil exporting countries are suffering from a rapid decline in oil prices. Economies of Russia, Iran and Venezuela and other countries without significant foreign currency reserves are under additional economic and political stress. Venezuela has been providing help to Cuba and the economic challenges that Venezuela is having may have been a factor encouraging Cuba to reduce its hostility and reach an accord with the US. It remains to be seen if Iran becomes more amenable to a nuclear pact and whether Russia elects to reduce tension in the Ukraine.

Distribution of the federal tax   The bottom 50% of US tax payers paid 2.8% of the total federal income tax in 2012, while the highest 10% (with 48% of the total income) paid 70% of the total tax, the top tax 5% (who accounted for 36.8% of income) paid 58.9% of the tax, and the top 1% (with 21.9% of the income) paid 38% of the tax.

About the author

Pinnacle Investment Management: Pinnacle Investment Management, Inc. is a comprehensive investment management and financial planning firm committed to the financial future of our clients.

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