January 14, 2015

Dear Client:

Q4, like all of 2014, saw more volatility yet the markets generally were positive. We maintained our portfolio positions despite the impact of falling oil prices.

Markets were solid for the quarter and year despite increased volatility. There were more down months and record highs than the previous two years. The Dow[1] recorded 38 all-time highs, while the S&P 500[2] had 52. US large cap and small cap equities all finished near record highs. The tech-heavy NASDAQ[3] posted the year’s best performance at +13.4%. Sectors were mixed with utilities and health care posting solid gains, while energy stocks lost ground. International equities disappointed with a drop of 7.4%. Global fixed income was generally positive with US long bonds the big surprise, up 21.7%. Commodities were the year’s big losers with crude -45.9%, natural gas -31.7% and copper -16.8%.

What happened? The fourth quarter could be called “The Return of the Consumer.” First, corporate earnings were strong with 67% beating expectations. Next, oil’s dramatic fall was estimated to add $800 to the average family’s income. A strong job market helped unemployment fall to 5.6% and little-mentioned wage increases for hourly and production workers. Add a 2.5% increase in productivity for non-supervisory employees, and the result was the highest consumer confidence reading in seven years. Since the consumer represents almost 70% of the economy, this has put US GDP and markets on an extended win streak.

The midterm elections changed Washington, DC. A surprisingly strong GOP showing increased their majority in the House, and gained control of the Senate, giving them the largest congressional majority since WWII. We even saw our good friend Charlie Baker elected as a Republican governor in a Democratic Massachusetts. The good news, the party seems to have moved to the middle and ignored calls to shut down the government. Instead, they passed a spending bill and promised effective government rather than gridlock. Positive. The Federal Reserve ended QE. Preparing investors for future rate increases, they said they will be “patient” in deciding timing. Now rates will be determined by market forces and not the “Fed Put.”

International growth has improved very mildly from last year. The Eurozone as a whole is the second-largest economic block in the world; and like the US in 2009, growth is not homogenous. Mario Draghi, the ECB President, continues to promise whatever liquidity is necessary, but so far the actual amounts committed have been limited. The area has benefitted from falling oil prices despite a falling Euro blunting the benefits. Japan has notched two quarters of contraction, leading to an early recall election which supported Premier Abe’s call for more stimulus. China, the largest emerging economy, has been hurt by slumping real estate and falling industrial production. We continue to expect them to undershoot growth projections. Falling oil prices will help most emerging economies, but will bite the Middle East, Russia, Africa, and other commodity-based economies. Overall, we see the international picture modestly positive.

Going forward – We think the beat will go on in the US and expect growth to be 3%+ for the year.   Plunging oil prices will be a big reason. We estimate it will generate over $200 billion in savings for the consumer, larger than the 2008 stimulus plan. They will have more to spend on cars, furniture and appliances. For corporations, oil is an input not an output. Low oil prices and a strong labor market equal positive momentum and also impacts many sectors. Energy capital expenditures only account for 1% of GDP and 1% of employment. This means other sectors of the economy will directly and indirectly benefit as energy costs for transportation and production fall, which will support profit growth. Bottom line – America’s finances are in the best shape of the decade, job growth is accelerating, incomes are trending up, corporations will have more to invest in buildings and software, and home building is expected to pick up. The US economy will be in the pink.

Q4 signs from Washington were promising. We expect more legislation to get passed and move on to the White House. At best, we will get good government policy which will look at entitlement, immigration and tax reform with an eye on removing obstacles to growth. At worst, our elective representatives will have to vote on issues and run on their record, not rhetoric. We also see a watchful Fed raising short-term interest rates by June which will be a signal the economy is healthy enough to stand on its own. Markets, not government, will drive economic decisions and investment values. All the above is positive.

The international front will benefit from a strong US economy and falling oil prices. In Europe, individual countries do not have the wherewithal to pursue fiscal stimulus. A cheaper dollar will create demand for their manufactured exports. Cheaper oil will help Eurozone consumers and offset the pain of austerity. Japan’s elections have supported continuing Abe’s stimulus programs, but he will have to get corporations to invest their cash hordes in Japan to escape recession. The hot economies of the past decade – the emerging markets of Brazil, Russia and China – will likely see their slowest growth in years. Falling oil and commodity prices will hurt their exports, and reduce foreign currency balances. They will have to implement delayed reforms for labor markets and government spending while passing business-friendly policies. We expect the international picture to improve slowly, but progress will be uneven by country and region.

Our Bottom Line – Clearly, we like the US economy and equities. But, we do expect increased volatility as government programs’ influence fades and market forces determine investment values.  Though surprised by the fixed income markets last year, we do not like bonds for two reasons: their low, inflation-adjusted rates of return and sooner or later interest rates will move up. Europe seems to us like the US back in 2009. There are more structural issues but we see many cheap companies which will benefit as their country’s growth picks up. Finally, emerging markets are starting to look attractive, but we will avoid commodity-based economies.

As always, we appreciate your trust. This letter provides our outlook of the most probable events, but at best is a summary. If you have any questions, please call us. Better yet, we would enjoy meeting with you to discuss our outlook and your current situation.

Yours Truly,

George Bernard, President

Doug Woods, Director of Research

[1] Dow Jones Industrial Average is an unmanaged index of the common stock prices of 30 widely held stocks, not including reinvestment of dividends.

[2] S&P 500 is an unmanaged index of the common stock prices of 500 widely held stocks and does not include reinvestment of dividends.

[3] NASDAQ is a market-cap weighted index of more than 3,000 companies listed on the NASDAQ Stock Market and does not reflect reinvestment of dividends.