1st Quarter 2015 Market Commentary

Index Performance

The market kicked off 2015 continuing the manic trend we observed all of last year. The first quarter finished decidedly underwhelming. For the quarter the Dow Jones Industrial Average ended negative, down .26 percent. It was a wild ride, though, with the Dow having daily moves greater than one percent a total of twenty times. The last time such activity was observed was the financial crisis year of 2009. The S&P 500 was able to eke out a positive return, up .44 percent at quarter end. And just like the Dow, the S&P’s volatility was exceptional: it had daily moves of at least one percent on almost a third of the first quarter’s trading days. The total return for the S&P was just below one percent. On a somewhat brighter note the Nasdaq Composite saw a 3.5 percent return in its ninth straight positive quarter. The riskier, more growth-oriented Investor’s Business Daily Mutual Fund Index was able to return 3.6 percent this first quarter. Bonds were also positive, if unimpressive: the Barclays Aggregate U.S. Bond Index returned 1.6 percent for fixed income investors. As we will explore in depth below, a host of factors is contributing to the market’s pronounced volatility and its inability thus far in 2015 to post consistent gains.

Domestic Developments

The American economy limped its way forward into 2015, chaotic yet cautious, ears perked to catch every last utterance of Federal Reserve Chair Janet Yellen. Here at home the effects of the dramatic drop in the price of oil continue to reverberate. At one point in March the price per barrel fell to a six year low, though it has since risen slightly. American oil and gas companies are beginning to feel the pinch as they halt drilling and have been laying off workers at a quick clip so far this year. Consumers hibernated the first quarter placing their windfall of cash from the gas pump into the bank instead of going out and spending it, perhaps dissuaded by the harsh winter weather. Economists are hopeful that the warmer weather will encourage folks to go out and spend and maybe provide the stagnant economy the booster shot it needs.

2015 is the year of the Federal Reserve, also known as the Fed. Since the recession of 2008-2009 the Fed has held short term interest rates at or near zero in an attempt to spur economic growth amidst the shambles. Our economy has undoubtedly improved since 2008 and the Fed now believes it is healthy enough for interest rates to begin to be raised this year. Precisely when this will happen is the question on everybody’s mind. Chair Yellen needs only string together the right sequence of words in her testimony and the markets react in either jubilation or horror. This is exactly what happened in March after Yellen removed the word “patient” in regard to when the Fed will begin to raise rates and hedged this deletion with the sound bite worthy, “Just because we removed the word ‘patient’ doesn’t mean we’re going to be impatient.” The market reacted accordingly, if arbitrarily, to this inferred postponement of rate raising: the S&P climbed 1.2 percent and bond prices shot up as well. Previous forecasts predicted a June interest rate hike, but after Yellen’s remarks and disappointing GDP and employment data (see below), very gradual raises are not expected to begin until the latter part of the year. The Fed’s noncommittal stance reflects a theme consistently highlighted in these pages: despite our politicians’ best efforts to convince us otherwise, our economy is middling.

International Developments

Worldwide economic stagnation continues to leave the United States the lone global bright spot and has reinvigorated the Yankee dollar as the reigning currency. The Chinese experienced slower growth in 2014 than they have seen since the early nineties, and foreign use of their currency, the yuan, has correspondingly decreased. Meanwhile the European Central Bank (ECB), through its President Mario Draghi, is battling a sputtering economy with massive quantitative easing (QE). You will recall from last quarter, when the Federal Reserve wound up our QE, that this stimulus program consists of the central bank purchasing large amounts of government and private debt securities. The ECB plans to purchase €60 billion worth of these securities each month with plans ultimately to inject over €1 trillion into the European economy through 2016. Likewise in Japan, Asia’s top developed market, the Bank of Japan is continuing its multiple trillion yen QE program of its own in hopes of combatting what many see as inevitable deflation (e.g. a negative inflation rate). All of these developments, along with the prospect of rising American interest rates (as discussed above) have led rather quickly to a strong dollar. While this is wonderful news for American tourists, the more competitive dollar will likely eat into the profits of multinational corporations whose goods and services are now more expensive for those outside the country.

Turning to geopolitics we find Europe suffering a crisis of identity and the Middle East escalating its perpetual state of conflict. Islamist terror attacks in Europe aimed at the heart of what western civilization holds dear—the freedom of expression—have inflamed the ever-present tension between natives and the unassimilated Muslim minority. This tension feeds into the rise of far-right political parties like the National Front in France and the UK Independence Party whose divisive rhetoric merely breeds further animosity. Conversely, the perceived failure of the European Union to lead its members to parity in economic prosperity has led to the rise of far-left political parties including Podemos in Spain and the successful Syriza in Greece. These leftists, in common with their counterparts on the right, chafe at the strictures imposed on them by the EU dominated by the wealthy, if dour, Germans. We will be observing further developments with our neighbors across the pond with great interest.

It would appear that our only friend right now in the Middle East is Israel, though you wouldn’t be able to tell as much from the actions of our President. The radical Sunni Islamic State is retreating, squeezed by falling oil prices and an Iraqi army revitalized with the help of Shiite Iran. Iran is also extending its influence across the region by backing the Houthi rebels in Yemen in their toppling of that nation’s Arab and U.S.-backed government. All the while Secretary of State John Kerry has been negotiating a deal with Iran that purports to limit the theocracy’s nuclear program. Whatever the result of these negotiations we can expect to see more sectarian skirmishes (Sunni vs. Shiite) as Iran gains more confidence and the Arab states respond in kind.

Consumer Confidence

Consumer confidence remains high as we close out the first quarter of 2015. The University Of Michigan Index Of Consumer Sentiment for March was an even 93. This number beats the non-recessionary year average of 87.4 and is well above March 2014’s index reading of 80. The most recent number, though, has been falling since the index recorded a spike of 98.1 in January. Economists attribute the spike to positive reaction to lower gasoline prices. The steady drop in the index since January has been blamed on inclement weather. We can expect the number to hover where it is or even rise slightly as weather improves and consumers start to spend their extra cash from the cheaper gas.

Gross Domestic Product

Unfortunately the momentum of economic growth we observed in the middle two quarters of 2014 was not able to be sustained through the end of the year. GDP for the fourth quarter grew at an annualized rate of 2.2 percent, down from the third quarter’s strong showing of 5 percent. Consumer spending increased while corporate profits fell 1.4 percent for the quarter and .8 percent for all of 2014. This is the first annual decline of corporate profits since 2008, though part of this decline may be attributed to both the precipitous fall of the energy sector and the stronger dollar making American goods more expensive for those living abroad to purchase. Additionally, government defense spending fell by 1.9 percent. Even slower growth is expected when the advance estimate for the first quarter 2015 GDP data is released April 29th. The pessimists at the Federal Reserve Bank of Atlanta predict growth of .2 percent and the optimists at JPMorgan foresee a mildly better 1.5 percent.

Employment/Labor Force Participation

The key word for the current market and macroeconomic trends seems to be tepid. Neither the charging bull nor the ferocious bear can be found hanging around Wall Street lately. The employment numbers for the first quarter of 2015 perfectly embody this trend of a lukewarm economy. The official unemployment rate for March was a good 5.5 percent. This is down from December’s 5.6 percent and over a whole percentage down from March 2014’s 6.6 percent. It should be noted, however, that job growth in March slowed considerably and posted its weakest gains since December of 2013. The percentage of total unemployed, the U-6, is down but still unacceptably high at 10.9 percent. What’s more, the labor force participation rate remains, as we termed it last quarter, a dismal 62.7 percent. We note again that this country has not seen such a low percentage of people working since the doldrums of the Carter administration in 1978. No doubt Chair Janet Yellen and the Federal Reserve are parsing these uninspiring numbers to determine how much longer to postpone the rise of short term interest rates.

Technical Market Overview

Extraordinary movement devoid of any progress pretty much sums up the first quarter of 2015. The S&P 500 index remains well above its 200 day moving average indicating that the bull market is still intact. It should be noted that the 200 day moving average is a long-term indicator and not designed for identifying market tops or short-term reversals. Volatility as measured by the VIX, was up 26 percent in January. Only three times since the VIX was launched in 1986, has the so called ‘fear gauge’ gained over 15 percent in January. Two of those times, the S&P ended the year down more than 5 percent. The third year, 1987, the market corrected violently in October, but managed to close the year with a positive return. That said, the erratic behavior outlined in the first paragraph of this letter highlights the rather conflicted behavior of the indexes. The Nasdaq Composite was the best performing equity market by a significant margin at 3.5 percent. This solid performance would appear to be confirmed by the Investor’s Business Daily Mutual Fund Index returning 3.62 percent, with many of the funds comprising the index having significant exposure to Nasdaq stocks held in the fund’s portfolios. The Dow Jones Industrial Average tells a different story for the first quarter, with 15 of its 30 stocks delivering negative returns for the first quarter offering investors a disappointing -.26% at quarter end. The Barclays US aggregate Bond Index delivered 1.6% to its investors perhaps indicating investors were more fearful of equity exposure than the much-anticipated increase in interest rates by the Federal Reserve Bank. While many, if not all, of the long term “technical indicators” remain intact, thereby suggesting a continuation of the present bull market, the market’s inability to show sustainable progress by moving higher may very well indicate the beginning of the top for this bull market.

Looking Forward

The so-called “January Effect” is a phenomenon that suggests that as the stock market goes in January, so it goes the rest of the year. Obviously January is only one of 12 months of the year, though it does have some history of indicating the market’s overall general direction for the remainder of a given year. The January Effect has been right in 62 of the last 85 years, or 73 percent of the time. Since 1929, the index followed January’s direction 80 percent of the time in years the index rose, and 60 percent of the time in years the index declined. More recently, in the past 35 years, the S&P 500 followed January’s direction 25 times, or 71 percent of the time (the Dow followed 83 percent of the time, and the Nasdaq followed 74 percent of the time). This January the S&P 500 suffered a 3% loss, the worst loss since 2009, and the largest monthly decrease in eight months.

The markets have plenty to be concerned about as we look forward in 2015. Decelerating corporate earnings, consumer’s reluctance to spend at a more robust pace and the impending increase in interest rates are all legitimate concerns facing investors. As you look deeper into the data that appears to be negative on the surface often the markets respond differently than one may think. For example increases in interest rates are widely considered to be a net negative to the equity markets. However, closer examination may bring you to a different conclusion. Note the following:

Start of Fed Rate-Hiking cycleS&P 500 returns over next 6 months
July 16, 1971 4.0%
August 31, 1977 -7.6
September 26, 198011.0
April 9, 19846.9
September 4, 1987-17.4
February 4, 1994-3.5
March 25, 199726.3
June 30, 19997.7
June 30, 20047.4
Average3.8 %

As you can see in the table above, six months after Fed began raising interest rates, six of the nine times the S&P 500 was higher by an average of 3.8%. With the anemic economic growth our economy is experiencing and the cautious approach the Fed is promising to take, it is quite conceivable that the inevitable rate hike may ultimately have a net positive effect on the equity markets much like the table above implies.

It is clear that the markets do not have a theme or an agenda on which they feel comfortable moving forward. We believe that is why we see the almost violent upward moves and, within days, equally violent contraction in the equity markets. Until the markets settle on a clear path forward, on such data as accelerated corporate earnings or leadership from the specific industry that they believe will positively impact the entire economy, it is quite possible the markets may remain in a trendless sideways trading pattern. As of the writing of this letter we can see no such dominant industry, nor does it appear that a re-acceleration of corporate earnings is imminent. Having said that, as you can see that indicators such as the “January Effect” and the notion that higher interest rates always have a negative effect on equity prices are only two pieces of a very complex puzzle and often are viewed quite differently by the markets than would appear on the surface. Quite simply there’s no way to forecast or predict what the markets will do, and that is why a risk appropriate structured portfolio management strategy is so important.

Risk Management/Investment Strategy

The portfolio management process used in identifying and making on-going investment choices to meet unique portfolio objectives, and which are consistent with particular risk profiles, includes the use of a sophisticated computer modeling system that analyzes price trends and many other factors at any point in time. It is important to understand that a model at any moment in time reflects all of the continuous inputs and is an observational process, not a predictive one. This means that models analyzed do not predict what the market will do, but rather simply observe what a market is doing and respond to it accordingly. Sufficient negative price movement will cause a model to move into a defensive position and, correspondingly, sufficient upward price movement will reduce defensive positions and increase exposure to the appreciating asset class. The adaptive nature of the modeling process helps to reduce risk/equity exposure in a portfolio as well as to respond to emerging up-trends in a way that adds meaningful value to a portfolio. Of course, there is no investment process or strategy, or any computer modeling system that can eliminate losses or guarantee positive results. However, a computer modeling system properly used, is a valuable resource in both implementing and carrying out the risk management/portfolio strategy undertaken in the management of portfolios.

THE WESTERMAN GROUP, LLC is a Registered Investment Advisor
Securities offered through MerCap Securities, LLC Member FINRA/SIPC
Office of Supervisory Jurisdiction 40 Darby Rd., Paoli, PA, 19301 (877) 784-8021
The Westerman Group, LLC and MerCap Securities, LLC are not affiliated.

Performance Disclaimer

No investment strategy or methodology can guarantee profits or protect against losses. Investment risk includes the uncertainty and volatility of potential returns for a portfolio or an individual investment over time. Investment risk is inherent in every individual portfolio and no computer model or modeling program used or relied upon in making investment choices for a portfolio can eliminate risk. A computer modeling program may not reflect actual risk and return parameters applicable to any particular portfolio or investor. Actual investment decisions made on the basis of a computer generated model or modeling program may be materially different from expected or intended results, and any computer modeling program is subject to errors in the program and system failures at any time.

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http://www.bls.gov (employment data)
http://www.finance.yahoo.com (indexes)
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