(PUB) Investing 2015

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Production Rebounds While Spare Capacity Abounds

Households Are in Good Shape

recent past into the near-term future. In simple terms, it means we think that what has just happened will continue to happen. If stocks went up, they’ll continue to go up. If interest rates went down, they’ll continue to go down. Why am I concerned about recency bias? Consider that 500 Index has gen- erated double-digit gains in five of the past six calendar years. The fund is up 103.6%, or 15.3% a year, over the past five years, which is attractive enough on its own but is downright seductive next to the returns of foreign stock mar- kets. 500 Index has outperformed Total International Stock in four of the past five calendar years, and its 103.6% gain is four times that of the foreign stock fund’s 23.6% return. On top of the raw level of returns, investors had a smooth ride to these heights. While U.S. stocks have on average experienced a correction of 10% or greater once every year and a half, it’s been over three years since large-cap stocks have pulled back that much. Daily volatility has been muted as well, with only nine days over the past three years when the Dow moved 2% or more on a closing basis—two of those were in 2014. The Dow hit 38 new highs this year alone and surpassed 18000 for the first time. All of this is not to say that U.S. stocks are headed for a tumble—in fact, as I’ll get to in a moment, U.S. stocks are poised to continue making gains in 2015. However, our tendency to look at the recent past and extend it forward— that recency bias—puts investors at risk of veering away from a well-diversified plan in favor of an overabundance of U.S. stocks after a period of exception- ally strong returns and low volatility. If your long-term approach is to be glob- ally diversified by holding some for- eign stocks, continue to do so. If your balanced approach includes an alloca- tion to bonds, don’t suddenly change that. It’s only a question of when, not if, we’ll get a 10% correction or more in U.S. stocks. I for one would welcome it, as it would remove some of the excess that creeps into any bull market.

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I’m expecting a bumpier ride in 2015, but I still think U.S. stocks can gain ground during the year. Why? Interest rates and earnings. I’ll come back to interest rates when I talk about bonds, but suffice to say that interest rates are low. Low rates make it easier for businesses to borrow for growth, and they also mean that bonds provide poor competition for investors’ dollars. Plus, valuations have historically been higher when interest rates were lower—it’s just a fact of investment life. Meanwhile, earnings continue to grow, and those ris- ing earnings will take the edge off what are high valuations today. Strong Man The U.S. is once again the strong- man on the global economic stage. It may not feel like it in every part of the country, but the U.S. economy is no longer recovering, it is expanding. GDP, whether you adjust it for infla- tion or not, hit new highs through the third quarter of 2014 and was growing at a 5% annualized rate as September ended (the most recent data available), the fastest pace of growth in more than a decade. This expansion can be seen in met- rics covering different components of the economy. Let’s talk about manu- facturing for a minute. The first chart above shows that U.S. industrial pro- duction, according to the U.S. Federal Reserve, experienced a classic and steep V-shaped recovery coming out of the financial crisis, and has since passed the level of production seen in the prior cycle. The chart also shows

that capacity utilization, which is a measure of how busy our factories and plants are, has returned to levels typically seen during a robust economy. When spare capacity tightens, it can create jobs, which can in turn increase demand—a virtuous cycle. The health of the U.S. consumer, who drives economic growth, continues to improve. In fact, by at least one mea- sure, the Bureau of Economic Analysis says that U.S. consumers haven’t been in as good shape for a quarter cen- tury. As the second chart above shows, when you consider “household debt,” which is the amount owed on mort- gages and consumer debt (think credit cards) relative to disposable income, the U.S. consumer is a powerhouse. Much-improved balance sheets mean there is plenty of ammunition to con- tinue spending, which in turn will move the economy forward. Another plus for consumers: During the first 11 months of 2014 (December’s numbers aren’t in yet) over 2.6 million jobs were created—the best perfor- mance in more than a decade. Going hand in hand with that, the unemploy- ment rate has dropped to 5.8% and the U-6 rate, which is a broader measure of unemployment, has edged down to 11.4%, further closing the gap between those looking for work and those who are not looking or are unemployed. Greasing the wheel for U.S. con- sumers are dramatically lower oil and gasoline prices. Crude oil is down over 50% since June, and lower prices at the pump are functioning like a welcomed tax cut for the typical U.S. consumer.

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