US stocks are still the best place to invest

Improving economic data helped to propel U.S. stocks higher in 2014.

For the sixth consecutive year, the S&P 500 index of large of U.S. companies generated positive returns.

It was also the third consecutive year that total returns for the S&P 500 exceeded 10%. Other major market sectors had significantly weaker performance than the S&P 500, with international stock markets suffering losses in 2014.

The Fed

After a weak first quarter, the U.S. economy picked up steam in the second and third quarters, with Gross Domestic Product (GDP) growing 4.6% and 5.0%, respectively.

The current unemployment rate of 5.6% is the lowest reading since July, 2008. GDP growth for the fourth quarter of 2014 is expected be by at least 3% and most forecasters are optimistic about further economic expansion in 2015.

Despite the recent economic strength, the Federal Reserve continues to passively stimulate the economy by indicating that it will be “patient in beginning to normalize” monetary policy.

Market bubble?

This essentially means that the Fed is in no hurry to increase interest rates. The Fed’s benchmark rate has been less than 0.25% since December, 2008.

The U.S. stock market has had strong rallies following each of the Fed’s past two policy meetings, as the Fed has reiterated its accommodative position.

While lower interest rates have kept borrowing costs low for businesses, and consumers and have likely encouraged economic growth, we have some concern that it has also created a stock market bubble.

Because interest rates are so low on fixed income investments, it appears that many conservative investors have shifted funds that would normally be invested in low risk bonds to riskier equities.

The Fed has held interest rates at artificially low levels for so long that many investors have lost perspective on where rates should be, considering general economic conditions.

Based on the historical relationship between interest rates and the level of inflation, we would expect that without the Fed’s actions, the 10-year Treasury bond would be yielding around 3.5% (it is currently 2.17%) considering the inflation rate (CPI) is currently 1.7%, according to our research.

Surprises

Probably the two most surprising developments of 2014 were the decline in long-term interest rates and the steep drop in the price of oil. Both of these trends can be linked, at least in part, to weakness in foreign economies.

In 2014, the yield on the 10-year Treasury bond fell from 3.03% to 2.17%. Declining U.S. interest rates usually correspond to a weak domestic economy. The current interest rate level seems to be totally inconsistent with an economy that is growing at greater than 3% annually.

Rather than indicating weakness in the U.S. economy, the low yield on the 10-year Treasury bond likely reflects global economic weakness. The 10-year Treasury competes with the sovereign debt of other major countries.

Bonds

The 10-year government bond yields at the end of 2014 for Japan, Germany, and France were 0.33%, 0.54%, and 0.83%, respectively.

Remarkably, the 10-year government bond yields for Italy and Spain (who are considered to be riskier issuers) stood at only 1.87% and 1.61%, respectively, at the end of 2014.

These foreign countries have employed easy money policies to stimulate growth, as both Japan and Europe have teetered on the brink of another recession.

So while a growing U.S. economy would usually push U.S. interest rates higher, the historically low rates of other countries have allowed the Treasury to attract global investors with an interest rate of just over 2%.

Energy bust

The second half of 2014 also brought an abrupt collapse in the price of oil. From July to December, the price of oil fell by about 50%.

While some of the drop was attributed to a greater supply of oil from shale projects in the U.S. global energy demand was lower than expected.

Slower economic growth in Europe and Asia was blamed for the slack demand. Lower energy prices should be positive for the economies of the major importing countries, including the U.S. China, Japan, India, South Korea, and Germany.

Stocks

As we enter 2015, the consensus view seems to be that the U.S. stock market is the best place to invest. Investors see a growing U.S. economy amid weakness across the rest of the world.

However, it is always best to be cautious when investors become convinced that a certain trend has been established.

For instance, gold rallied to almost $1900 an ounce in 2011 on the belief that the coordinated stimulative monetary policy of major central banks would create inflation. Gold now sells for less than $1200 an ounce and inflation is almost nonexistent.

In June, when oil traded above $100 a barrel, investors believed oil prices would continue to rise due to the ongoing conflict in the Middle East (with ISIS capturing oil fields), supply disruptions in Libya and Nigeria, and concerns about the effects of economic sanctions on Russia. As noted previously, oil prices have nonetheless declined by approximately 50%.

Risks

Therefore, despite the apparent attractiveness of the U.S. stock market, we believe it is best to be cautious and well diversified going into 2015. First, we think there is some possibility that earnings growth for U.S. companies will fall short of expectations.

Considering approximately 45% of the earnings of companies included in the S&P 500 are from foreign operations, slow international growth and a strong dollar (currently at multi-year highs versus the euro and yen) could have a negative impact on earnings.

Second, valuations of U.S. companies are relatively high compared to historical levels and other markets. The price/earnings (P/E) ratio of the S&P 500 is 16.6 times 2015 estimated earnings. This ratio is about 15% above its historical average.

The total value of the U.S. stock market (as measured by the Wilshire 5000 Index) is currently $21.2 trillion, which is equal to 1.17 times U.S. GDP.

The only other period when this ratio was at a higher level was in the year 2000 when the ratio reached 1.43, prior to the collapse of the “Dot Com” bubble.

At the market peak in 2007, the P/E ratio for the S&P 500 was 16.0 times estimated earnings and the U.S. market value to GDP ratio was 1.05.

Valuations

The higher valuation for U.S. stocks stems in part from the fact that stock prices have increased at a much faster pace than corporate earnings.

In the past three years, the S&P 500 index has advanced by 63.7%, however, the combined earnings of the S&P 500 companies have increased by just 21.1%.

Historically, these two measures have been more closely tied. Furthermore, much of the earnings gains have resulted from cost cutting and stock buybacks, as opposed to organic sales growth.

History has shown us—as with gold in 2011 and oil in 2014—the consensus view can often be wrong in expecting current trends to continue indefinitely. By chasing performance, investors subject themselves to sharp corrections when trends reverse.

While we are not forecasting a correction for the market, if one occurred, it would not be a surprise. The current bull market, which began on March 9, 2009, is now the fourth longest on record (since 1928).

In summary, we enter 2015 with the U.S. economy at it strongest point since the last recession. While this bodes well for corporate earnings, much of the good news might already be reflected in current stock prices.