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 29^th at 1995, and then proceeded to fluctuate in a fairly narrow range, peaking on March 1 at2117. 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 4^th 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

Posted April 30, 2015 at 1:45 PM