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Scott Investment Advisors, Limited Partnership
QUARTERLY INVESTMENT REPORT
1st Quarter, 2015
REVIEW OF MARKET PERFORMANCE
The stock market whipsawed throughout January as various global issues were wrestled with by
investors. The decline in oil prices and corresponding uncertainty as to the economic
ramifications became more of a central issue as prices fell through the $50 mark and continued to
trend downwards. The stock market was temporarily boosted when the European Central Bank
announced its launch of a quantitative easing program. However as global interest rates fell, the
U.S. dollar gained further strength, adding another concern for investors that corporate earnings
would be pressured from adverse currency translations. This was reinforced by company
spokesmen as earnings reports were released. The S&P 500 Index lost -3.1% in January, making
it the 2nd month in a row of lost ground.
The market meandered upwards in February as investors sought new opportunities after the
market decline the previous month. A strong employment report during the first week helped
provide fuel. International news turned more positive including a better than expected 4th
Quarter GDP report from the Eurozone, a temporary resolution of the Greek debt problem, and a
ceasefire agreement between the Ukraine and Russia to end hostilities. On the negative side, the
U.S. 4th Quarter revised GDP report indicated the economy only grew by 2.2%--an indication
that the current Quarter had probably started off in a lower growth mode than had been
anticipated. However given the mostly positive news, the market wound up having an excellent
month with the S&P 500 index gaining 5.49%.
A record high was attained by the S&P 500 index on the first trading day of March, but slid from
there over the rest of the month. The market gathered downside momentum during the 2nd week
as the dollar continued to rise, reaching a 12-year high. However a full scale downturn was not
to be, as the low for the month was reached on March 11th, with the S&P 500 index only having
lost -3.05% in price at that point. During the 3rd week, the Federal Reserve released its latest
policy statement reflecting dovish tones, indicating they were still in no hurry to raise rates. The
market raced ahead on the news, but came down to earth near month-end as headwinds blew
stronger including an escalating conflict in Yemen, and disappointing economic reports.
Through all the ups and downs during March, the S&P 500 index wound up losing -1.74% in
price. For the 1st Quarter, the S&P 500 Index made a price gain of 0.44%.
Broad Market Index (BMI) Funds:
Small to mid-sized index funds made the strongest gains by far (especially those having a
growth-orientation), while larger company index funds languished by comparison. For example,
the top performing index fund was the S&P Mid-Cap Growth fund (IJK), with a gain of 7.5%,
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while the worst performer was the Russell Large-Cap Value Index fund (IWD), which actually
lost ground, (-0.8%). Among the larger company BMI funds, the S&P 500 Pure Growth fund
(RPG), performed best (up 4.6%), reflecting its smaller average company size and higher growth
orientation. It appears the current favoritism shown smaller company stocks reflects investor
concern over the comparatively higher foreign exposure by larger company stocks combined
with the negative effect on overseas earnings of recent dollar strength. Additionally, smaller
company stocks are not as stretched on a valuation basis as are larger company stocks. Thus
with company earnings set to be released beginning in mid-April, investors may see less risk of
negative earnings surprises for mid-cap and small-cap stocks.
Sector Index Funds:
Returns among specific sectors was particularly diverse with several sectors producing doubledigit gains while several others fell into the red. Various healthcare sectors including
Biotechnology (IBB) were the leaders, with the Pharmaceuticals sector (IHE) on top, producing
a gain of 14.2%. The Biotech sector has been particularly volatile this Quarter given a mixture
of good news amidst bouts of profit-taking. At one point, IBB was up 21.0% in the Quarter, but
wound up with a gain of a little over 13% at the end of March. The Home Construction sector
(ITB), was also among the leaders with a return of 9.2%. Among the weakest sectors were
Utilities, Transportations, Energy, Financials, and Basic Materials in that order with the Utilities
sector inhabiting the cellar. All had negative returns for the Quarter.
Foreign Market Index Funds:
The foreign markets had a much stronger Quarter than the U.S. market as economic data
overseas began to surprise on the upside while U.S. economic data did quite the opposite. For
example, the world market ex US (ACWX) returned 4.0% vs. the S&P 500 Index fund (IVV)
returning just 0.9%. Japan (EWJ) was the top performing foreign index fund, returning 11.4%,
while the markets of Denmark (EDEN), Italy (EWI), Germany (EWG), and the Philippines
(EPHE) were also among the leaders. On a regional basis, the Asian market performed best.
The European region (IEV) produced returns at around the 50 percentile among world markets,
but still performed significantly better than the U.S. market. The Latin American market (ILF)
was exceptionally weak however as 3 primary countries of this region had their markets fall into
the red. Leading the way down, the Brazilian market continues to be plagued by the Petrobras
political scandal, and lost -14.1%.
Income Funds:
Thanks to another Quarter where U.S. interest rates have backed up, longer maturity bond funds
performed best among all income funds. The best performer of all was the 20+ year T-Bond
fund, returning 4.2%. The Emerging Markets Bond ETF (EMB) was 2nd best with a gain of
2.9%, reflecting improvement in the outlook for some emerging market economies. High Yield
bonds (HYG) also had a good Quarter (producing a return of 2.0%) in spite of signs of a
sputtering U.S. economy. The ECB’s announcement of a quantitative easing program in late
January served as a catalyst to both foreign and domestic investors to seek yield. Additionally,
investors grew less worried over negative repercussions a continued drop in oil prices might have
once oil prices stabilized. (Note: the high yield market has a roughly 15% exposure to the
energy sector.) In terms of alternative income funds, the iShares Preferred Stock fund (PFF)
performed best this Quarter, returning 2.6%. The iShares Select Dividend fund (DVY) has been
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among the weakest income funds, producing a negative return of -1.1%. The problem with DVY
has been its high exposure (33%) to the Utilities sector--which has been very much under
pressure due to the weakness in energy prices as well as due to growing expectations of an
increase in the Fed Funds rate that would tend to make bonds more competitive to equity
income.
ECONOMIC ANALYSIS
GDP
Economic weakness has deepened, and become more widespread across sectors. The 4th
Quarter GDP report of just 2.2% now appears to be part of slowing trend rather than a 1-quarter
anomaly many had predicted. Manufacturing has been particularly soft due to several
constraining pressures including the rising dollar pinching export growth, a cutback in business
spending, and a steep decline in demand for equipment associated with oil drilling and mining. .
The consumer hasn't helped matters either in spite of a pickup in income. Although consumers
have recently gained a significant boost to their budgets from the sharp decline in gasoline costs,
it hasn't (yet) translated into a demand pick up in other areas. Instead, the personal savings rate
has been rising, recently hitting a 2-year high. Recent data on housing activity has been mixed,
but lack of first-time buyers has been of concern by builders. The Index of Leading Economic
Indicators has been up just 0.2% over the last two months after reflecting better numbers in the
previous Quarter. We note the jobs market had been a bright spot until the latest report (see next
paragraph). Earlier employment reports had been the source of some optimism that the current
economic weakness is just a flash in the pan. However all factors considered, we believe the
current weakness will be more prolonged before picking back up towards year-end. We now
expect GDP to grow at about a 1% annualized rate this Quarter, with only slight improvement in
the 3rd Quarter.
Employment
The slowing economy finally took its toll on the labor market as the just-reported numbers
for March were considerably weaker than recent trends. Just 126,000 new jobs were
created, breaking the streak of over 200,000 new jobs gained over the past 12 months. The
Quarterly average fell to 197,000 per month vs. 289,000 the previous Quarter. We note it has
been widely held that growth would soon resume after a brief slowdown that has been influenced
by harsh winter weather. However we believe the weak March report will likely change this
attitude among many economists. We believe this latest weak jobs report is in fact right on
schedule given employment is always a lagging indicator of the current economic environment.
However the unemployment rate still held at its previous 5.5% rate, a recovery low. This likely
reflects a depressed labor participation rate at a historically low level. Wage gains were up
slightly, but they haven't moved beyond recent averages in a range around 2.0%. We expect to
see the jobs market go through a weak cycle from here before getting back on track perhaps
during the 4th Quarter.
Interest Rates
In spite of expectations for the Fed to finally embark on a rate-raising program sometime
this year, bond rates headed downward over most of March. The 10-Year Treasury ended
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the month at 1.85% vs. 2.0% at the end of February and 2.17% at the end of 2014. The only time
this Quarter when interest rates were lower was during the last half of January when the 10-Year
Treasury dropped to a recovery low of 1.68%. Pressuring rates downward were a combination
of the European Central Bank embarking on lowering longer term interest rates through its "QE
Program" (similar to the one that had been employed by the U.S. Federal Reserve), dovish
guidance from the Fed, and weakening U.S. economic data. The average 30-year fixed
mortgage rate fell to 3.70% as compared to 3.80% as of the end of February.
Although the Fed's latest announcement removed the word "patient" in referring to their timeline
for raising rates, they also added some qualifications which we think will push it off beyond this
year. For example, they cited concern for the strong dollar affecting economic growth while
keeping inflation down. Raising rates would likely strengthen the dollar further. Perhaps the
most difficult prerequisite they laid out for raising rates is for the inflation rate to be headed
towards a 2% target. Presently there isn't the slightest whiff of inflation, and with the economy
appearing to be on a more moderate growth path, it seems unlikely to occur anytime soon.
Inflation
Consumer inflation (CPI) was 0.2% in February, the first positive number in 4 months. On
a year over year basis, CPI has become flat (0.0%); excluding food and energy, CPI on a yearover-year basis has increased at a healthier 1.7% rate. However the Fed looks at another
inflation monitor known as PCE (Personal Consumption Expenditures). Differences between the
two measures include the fact that PCE is more comprehensive. We also note that historically,
PCE tends to reflect lower price gains than CPI. The most current PCE (for February) is 0.3%
year-over-year. Expectations for wage inflation to finally begin to take root has been high for
months, yet it hasn't budged in spite of the significant decline in the unemployment rate over the
past few years. Should the rate of job growth begin to fall to lower levels this year as we've been
predicting, we don't expect PCE to change much from here, especially given ongoing
countervailing deflationary pressures including the continuing effects of much lower energy
prices. We note the Fed's latest prediction for inflation in 2015 is just 1.0%, which is a far cry
from their 2.0% target which they say inflation should be closing in on before they move to
increase rates.
Housing
The outlook for the housing industry continues to be mixed. However it has been difficult to
ascertain its true status given heavy storms that have come and gone among different parts of the
country. Existing home sales have been up and down, but remain in a range considered weak
relative to historical averages. New home sales are on a roll right now, but builder sentiment has
been falling while construction spending has also been weak. The NAHB Housing Index
indicates a lack of "traffic" among new housing projects. At the same time inventories have
fallen back to low levels, which could pressure future sales if the supply of homes on the market
don't increase.
Corporate Earnings Outlook
Earnings for S&P 500 companies have not deteriorated any further since last month's
report according to data attained from Factset. In February's report we discussed the big
slide in corporate earnings due in large part to the fallout from the decline in oil prices. We find
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it of some comfort that no more damage has shown up at this point after the initial impact. Thus
soon-to-be reported 1st Quarter earnings are still on track to decline by -4.6%. It will be the first
time since the 3rd Quarter of 2012 that a quarterly decline in earnings has occurred. The
downward revision to earnings growth as compared to estimates as of the end of 2014 is -8.2%.
While the market decline in March has reflected some degree of discounting, we are wary as to
whether most of the bad news has been fully factored in. Given the continued weakening of the
economy and the outlook for an ever stronger dollar (which limits export growth), our main
concerns are whether the market has fully discounted earnings from companies with strong
overseas exposure and whether company outlooks will live up to current expectations. At
present, earnings growth of 2.4% is projected for the entire year of 2015. This compares with
8.4% estimated at the end of 2014.
P.O. Box 1271 / 349 East Kelly Ave
Jackson Hole, WY 83001
60 Sixtieth Place
L ong Beach, CA 90803
Phone: (307)529-0968
sam@scottadvisors.com
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