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The Cornerstone Investment Commentary: End of Year 2014

Last year this time, were someone to have predicted for 2014 that 1) oil prices would fall by nearly half; 2) any concerns about rising inflation and interest rates were misplaced; and 3) the world’s most highly-valued major stock market – the U.S. – would also be its best-performing, he/she could now sell their ‘crystal ball’ for quite a nice price!  On the other hand, those whose rational analysis led them to ‘lean against’ any of these with their investment portfolio paid a hefty price for being on the losing side of such bets.

How did all this happen?  First, the highly-inelastic demand for energy (where small changes can significantly affect prices) led to big price drops as growth in the world’s emerging economies (especially China) slowed; this was true despite despite faster U.S. economic growth and the continuing supply boost from shale gas production.  Clearly, there will be winners and losers in all this, particularly if lower prices continue.  Regarding the inflation and interest rate non-event, the Keynesian diagnosis has proven correct:  as long as there is slack in the job market and banks/businesses prefer to keep much of their excess capital liquid rather than ‘invested’, inflation and interest rates shouldn’t move much.  And U.S. stock market gains reflected growing corporate profitability as consumer spending increases from the ~3 million new ‘jobs created’ and redirected savings at-the-pump put more money on companies’ bottom lines.

As for your portfolio relative to these three events, 1) our mid-year decision to sell your commodities position (avoiding a 24% drop) and reallocate these funds in U.S. Real Estate (reaping a 10% gain since July) proved quite prescient, together adding over 1% to 2014’s total gain; 2) holding the majority of your fixed income assets in shorter-term bonds caused us to miss some of the bond market’s rise, though recent research favors shorter-term bonds for both retirees and near-retirees; and 3) having 70-75% of your overall equity position in the U.S. market clearly benefited your 2014 results.  (As a reminder, 40% of the Defensive and Global Dividend categories are U.S. stocks.)

This raises two obvious questions:  What does all this portend for 2015?  And what, if anything else, should be done at its outset?  First, as you know, we don’t make prediction ‘bets’ with your portfolio (though that is certainly a popular sport this time each year).  More important, the investment results you need to successfully achieve the life goals your portfolio is to fund do not require correct predictions/guesses/bets.  In baseball terms, you don’t need home run years but you do want to avoid ones that are strikeouts.  Since it’s the home run sluggers who strike out the most, hitting mostly singles and doubles is the key.  That said, the increasingly good U.S. economic news (higher growth, lower energy prices and recent rises in corporate investment) which points to higher profits should not be ignored.  Neither should eventual interest rate increases or the headwinds to many foreign emerging markets from a rising U.S. dollar and the falling prices of commodities they sell.

Under such conditions (and desiring to minimize strikeouts), your portfolio’s positioning looks just about right.  Increasing your U.S. stock market exposure seems unwise given high valuations for large-cap and small-cap stocks.  So too would be buying more longer-term bonds with hard-to-justify hopes that interest rates will fall still further.  We do, however, think it best to reduce your emerging markets position by 20% in light of their U.S. dollar and commodity price headwinds and to reallocate these funds to increasing your U.S. Real Estate holdings which are more fairly-valued and should benefit from further economic expansion.  This is easily done with low-cost, exchange-traded index funds (ETFs).  And we will continue to rebalance your portfolio as markets ebb and flow while also keeping a watchful eye on how these trends unfold.

As always, we welcome your comments or questions on your portfolio’s investment policy and thank you for the continuing opportunity to work together.  We look forward to our conversation at your next review meeting and send you our very best New Year’s wishes until then!