December 2014

“It is always wise to look ahead, but difficult to look further than you can see.”

- Winston Churchill

We know better than to make rash predictions about the stock market.  Still, part of our job at Talbot Financial is to try to see around the next corner.  With this in mind, about this time last year, Talbot Financial was doing its best to look forward into 2014 with our “future glasses.” 2013 had been a good year….as had 2012….and 2011….and 2010. 

In fact, as we were pondering the future, the S & P had already risen from its March 2009 low of 667 to nearly 1800.  And when you look at earnings improvement and balance-sheet restructuring, there was good reason for the rise.

Still, we wondered:

  • Was “the market” too high? 
  • Were we due for a correction?
  • Was it time to get even more defensive?

Yet, as we looked at the balance sheets, income and cash flow statements, and earnings reports of the companies we owned, things weren’t as “toppy” as many seemed to be saying.  Additionally, Bloomberg’s average analyst estimates for 2014E & 2015E future earnings and revenue growth for our portfolio companies were solid, pretty much across the board.  Yes, stock prices were up….but, for many companies, so were earnings…and margins…and revenues.  And since our philosophy has always been to invest in companies, and not markets, we chose to stay the course. 

That meant continuing to invest in large, mainly US-based corporations with multi-national reach….provided they had a reasonable PE ratios, strong earnings, growing top and bottom lines, experienced management teams, and enough cash to pay dividends on a steady (or rising) basis.  This is the mantra we employed in 2010 and still have today.

That turned out to be a good decision for 2014….at least with two weeks remaining before year-end.  For the most part, our large cap diversified line-up of stocks has performed well. 

The pleasant surprise to us though was the number of our portfolio companies that chose to both increase dividends and to buy-back shares in 2014.  This one-two punch provided a floor to corrections we saw along the way this year.  Downside volatility, while normal, was also short-lived.

Still, we did not get it all right. 

In December 2013—as we sat pondering—some things seemed certain.  Interest rates had to rise.  “Everyone” knew the Fed was clearly serious about tapering its bond purchases—and without $85 billion of Fed money pouring in every month, who would buy all those bonds?  Rates would have to rise to attract new buyers—and as rates rose, the exodus from bonds would be ugly.  We therefore concluded that bonds were over-priced….and long term bonds would be the most expensive of all.  

We were wrong. (So far) 

Not only did rates not rise, they continued to fall!  In a world where 80% of the world’s economies are now underpinned by 0% interest rates, U.S. bonds actually paid higher than that of most other countries around the globe.

The U.S. did not have to raise rates to attract buyers.  In fact, the U.S. could lower rates and still have global investors fall all over each other to get 2.05%-2.75% on our a 10-year notes.   After all, Germany was paying .71% and Japan .43% for notes of the same maturity.  Even Spain (of PIIGS fame) was paying only 1.8% on 10-year paper.  Spain at 1.8% or the U.S. at 2.25%, hmmmm, which would you choose?  (Hopefully, not the Ruble!)

The result was TLT (the bond Exchange Traded Fund that tracks U.S. bonds of 20+ year maturities) soared.  As we pen this blog, the TLT is up 27% YTD vs. 10.48% for the S & P 500.  In fairness, the two-year return for the TLT is closer to -2%, while the S & P is up over 40%.  Still, for 2014, long term bonds posted higher returns than a broad based equity portfolio.

The other big surprise for us was the cliff in energy prices.  We believed the forecasts for global recession were overstated.  And while growth rates would slow, growth was still growth—and the world’s “economic pie” was growing.  We believed demand for energy would rise steadily.  And we were right. 

Yes, Japan experienced yet another recession, but China (along with other Asian economies) grew.  Europe saw slow-but-steady recovery—something that seemed nearly impossible during the Greece-Portugal-Italy-Spain crises of previous years.  And, here at home, GDP grew, unemployment fell, inflation remained low, and innovators continued to innovate.

So while we got the demand side of energy right, we got the supply side wrong.  We knew fracking was real.  We knew U.S. production was rising.  What we didn’t know was how much (and how fast) both U.S. and foreign production would rise.  This is mainly a U.S. success story that we underestimated.  Drill baby, drill worked!

Not only did production rise, but technological advances made that rise happen at lower costs.  In December 2013, we weren’t prepared to say, “The U.S. will soon be the number one oil producer in the world!”  Yet, one year later, we are on track to become exactly that.

The result is, as the Saudis saw a real threat to their market share, they decided to intervene—even if it meant some pain to their own budgets.  So, oil prices have been falling, and falling, and falling.  This is wonderful for the overall economy, but bad for energy stocks.

This does not mean we are abandoning our energy positions.  In fact, within the energy sector, for 2014 we chose wisely.  It has been the large multinational companies like Exxon, Chevron, and ConocoPhillips that have performed the best.   Plus, they continue to reward shareholders with rising dividends.  

Remember, management teams of the largest companies have seen all this before.  They did not get exuberant in 2008 when oil hit nearly $150/bbl….nor did they panic when it fell to $45/bbl one short year later in 2009.  No, as per usual, it is the smaller, over-leveraged, & less experienced companies that tend to suffer when politics holds sway over economics.  This is when the larger firms tend to buy the struggling firms at bargain basement prices.  Then, when oil prices rise, they are the disproportionate beneficiaries.  In fact, we are starting to see this phenomenon begin already. 

Finally, we have consistently said that a very logical parallel investment to equity exposure in stocks is real estate.  For many, a home provides this exposure….and 2014 has provided some nice appreciation.  In addition, cash positive, conservatively leveraged real estate (while Illiquid) can perform very well over the long term—particularly if inflation rates rise.  We liked this exposure last December...and like it still today.   We believe the combination of income and asset appreciation from real estate will outperform cash flow from bonds with the acknowledgement that risk is higher real estate.  We certainly like, however, the risk/reward ratio we are presented in today’s market.


So, in hindsight, we got most things right and a few things wrong.  Thus, our 2014 “future glasses” must have been just like Winston Churchill’s –bifocals.  Next month we’ll have our 2015 glasses cleaned and polished.  Happy Investing!


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