Now but a distant memory, the fourth quarter of 2014 in fact began with the turbulence of early October, stocks were down and volatile; pundits were unanimous that it must be the beginning of that long waited correction. After all, stocks were overvalued; earnings growth had been slowing, the Fed were on the verge of ending the QE program. Markets may be explainable over the long term and often with the wisdom of hindsight, but just like the arrival of that heavenly kingdom, none can divine its timing.
Steadily, stocks recovered. Eventually, S&P 500 gained 4.93% during Q4 of 2014. For the year, it was up 13.69%. But it was not euphoria everywhere. Active fund managers had the worst performance relative to the S&P 500 in decades since most of them consistently favored smaller market capitalization stocks. The Russell 2000, an index of smaller company stocks rose only 4.9% for year. As interest rate sensitive Treasury rallied, credit sensitive high yield bonds faired much poorer. So clearly, certain segments of the market were more cognizant of the inherent risk of this aging bull market.
In a survey conducted by the Wall Street Journal in January, 2014 on interest rate, 48 out of 49 economists surveyed predicted that interest rate on 10 year Treasury will rise and exceed 3% by year end. Yet on the last day of 2014, 10 year Treasury stood on the yield of 2.2%. It was yet another reminder of the difficulty in forecasting and the global nature of economies and markets. While the US Federal Reserve indeed was on the path of winding down its quantitative easing program, the rest of the worlds were just getting started. The massive QE programs in both Europe and Japan ensured that liquidities were ample and bond yields around the global remained tethered the determination of central bankers.
The other great surprise of 2014 was the collapse of oil price. WTI stood at $95 a barrel and finished 2014 at $54. Most of that drop occurred during Q4 of 2014 and was attributed to over supply by most experts. Yet oil prices had held up well through most of the year while supplies steadily increased. The abruptness of the collapse must also bring forth the possibility that global economic growth were even weaker than thought.
So we enter 2015 with a relatively healthy domestic economy, but much weaker economies globally. While US central bankers are reigning in the stimulus program, global central bankers are biased to increase such programs. As a result, liquidity will remain stable and earnings growth will likely be subpar. Given the higher than average valuation and frothiness of year end trading, it is best to be somewhat cautious in the near term. However, as long as interest rates remain supportive of asset values, we expect equity valuation to remain at present level for 2015.
Dong Hao Zhang
President & Chief Investment Officer Evla Hills Investment Management