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From The No-Load Fund Investor, 1/15...
The U.S. equity market outperformed most foreign markets in December. While the large-cap S&P 500 lost 0.4%, the MSCI EAFE Index of foreign developed markets declined by 3.5%. For all of 2014, the pre-dividends performance gap between these two indexes was a whopping 18.7 percentage points: +11.4% for the S&P 500, vs. -7.3% for the MSCI EAFE.
Within the U.S., large caps trailed small caps in December but outpaced them by substantial margins for the entire year. The Russell 2000 Index of small companies gained 2.7% for the month but only 3.5% for the year (pre-dividends).
The average ‘value’ stock fund in our database gained 9.2% for the year, vs. 8.2% for the average of the ‘growth’ funds we track. For the past three years, however, growth is slightly ahead: an annualized gain of 19.3%, vs. 18.8%.
For the year, the best performing sectors were healthcare and utilities. The worst, of course, were energy and the broad natural resources area, funds of which produced an average loss of 14.2%. In the past six months alone, the average loss has been 27.4%.
Best Buys Commentary. We have decided to make no changes in Best Buys this month. After their great performance last year, healthcare and especially utilities look expensive. If we had the latter in our models, we would probably cut back on the exposure. (We are keeping the healthcare.) There is “blood in the streets” when it comes to the energy sector, so the contrarian in us is whispering in our ears to recommend the implementation of some pure exposure there. However, we suspect that the supply/ demand situation for oil will take a while yet to adjust in favor of higher oil prices, so we are going to hold off.
Forecast for 2015
In our stock market outlook for 2014 (“Forecast for 2014,” January 2014),we expressed a moderately bullish view. We identified several positive factors, including low interest rates, reasonable equity valuations as compared with low interest rates, an improving economy with little inflation, exceptionally friendly monetary policy from the Federal Reserve Board, and the strong balance sheets in the U.S. corporate sector. Specifically, we forecast a total return for the year from the U.S. stock market of between 8%and 12%.We also said we felt large-cap U.S. stocks were much more attractively valued than small-cap stocks, and would have a better year as a result.
We were right on both counts. The broad U.S. stock market gained about 12.5%in 2014, while the gains were centered in the large-cap segment of the market. For example, while the Russell 1000 Index of relatively large companies gained 13.2%, the small-cap Russell 2000 Index gained less than 5%.
Because we believe in diversification through the spectrum of market capitalization and across various types of assets, none of our Best Buys models had a chance of beating the broad U.S. stock market in 2014. However, because we maintained substantial equity allocations, readers who invested according to our general advice achieved handsome gains.
1.) While the market’s current valuations are above average, they are not alarmingly high.
The S&P 500 Index of large U.S. companies has a price/earnings (P/E) ratio of about 19 on operating earnings achieved over the past 12 months (‘trailing’ earnings). A year ago, the P/E on trailing 12-month earnings was also about 19. However, on cumulative, projected per-share earnings for the next 12 months (‘forward’ P/E), the S&P 500 has a P/E of about 17.3.
The median P/E of the S&P500 during the post-WorldWar II period has been slightly more than 15. However, the market has generally performed at least okay with a P/E within a few percentage points of the median. It has mainly been when the market P/E has exceeded 20 or so that returns over the next several years have been paltry, or negative. (There are exceptions to this, of course.)
It’s also important to look at valuations across the market. For example, if the largest stocks have low valuations, their outsized weightings will bring down the overall P/E and present a misleading picture. This is especially true for investors in actively managed stock funds, few of which concentrate their assets in the index’s largest companies. By this measure, the market is a little more expensive than the simple P/E of the index would suggest. For example, while the Russell Top 50 “mega cap” companies sport an average P/E of 17.7, an equal weighting of all of the stocks in the S&P 500 has a P/E of above 20. Meanwhile, the P/E of the Russell 2000, while not as scary as a year ago, is still somewhat high at about 21.
For details from our Forecast for 2015, see the January issue of The No-Load Fund Investor.
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