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Quarterly Letter to Clients

January, 2015

Indices at quarter-end (December 31, 2014):

Dow Jones Industrials: 17,823.07 4Q'14 +4.58% YTD +7.51%

Standard & Poor's 500: 2,058.90 4Q'14 +4.39% YTD +11.40%

Toward the end of the year there was a bit of excitement in the market. In mid-December stocks were rattled by international markets and by oil's steep fall. The selloff in stocks was brief and sharp but so was the rebound, carrying us to new highs. For the year we ended up with decent returns in stocks and, somewhat surprisingly, in bonds. Following an exceptional 2013 we can only be pleasantly satisfied.

Outside of oil, nothing in the financial markets is cheap today. We have now had six consecutive years of stock market gains. While the decade of the 1990's had nine consecutive annual gains, I assure you such periods are very rare. The simple fact that the market has gone up for six years doesn't mean that there aren't any good investments. But it becomes increasingly difficult to justify an investment when you have in the back of your mind the thought that prices may well be lower a year or two from now.

If six years of rising stock prices have you on edge, chew on this: bonds have been higher in 22 of the last 26 years (which is the extent of my records).

Just incidentally, and probably contributing to the advance, the U. S. dollar was consistently strong during 2014, posting gains for the year over every major currency.

"Peak oil" is the theory that the world will reach a point where there is no more oil to be discovered, consumption is greater than production, and we basically begin to run out of oil. The theory was first promulgated in the 1950's; at that time it predicted 1971 as the time when we would run out of oil. 1971 came and went, of course, and new discoveries have consistently pushed that theorized "tipping point" further into the future.

I mention this not only to highlight the folly of making predictions in general, but because of what has happened lately in global oil markets. With new production from shale deposits, we have become a much larger factor in supplying the fuel that we as a nation depend on for our autos, trucks and heating. That new supply has been a factor in the drama of oil prices.

From over $105 a barrel in July, West Texas Intermediate crude oil fell to a five-year low under $53, a decline of almost 50% in five months. All commodities, of course, are volatile, and we see the prices change every time we fill our tanks. In 2005-2007 oil went from $45 to $140, and then in 2008-2009 that same oil contract went from $140 back to $45. So this latest move is not unprecedented, but we're human, and we tend to ignore history and to think that current conditions will be permanent. They're not.

Oil's volatility has economic ramifications across almost all industries. For oil producers, and for nations that rely on selling their oil, the implications are negative. And our nascent "fracking" sector is already feeling the negative aspects of the price decline. If it costs more to bring oil to the surface than what you can sell it for, new projects will be put on hold, and the industry overall is likely to slow significantly. Needless to say, oil stocks have been relentlessly hammered.

But for most industries the price decline is a plus. And if we look at what happened to stocks during the previous boom-bust cycles, we might be further encouraged.

The American consumer will be a big beneficiary of the gloom in the oil industry. Prices at the pump are down over a dollar a gallon since June of this year. Some are calling it a wage increase for the middle class. The extra dollars in consumer's pockets should result in more spending in other areas, though it is hard to argue that pulling dollars from one industry and injecting them into other industries has any real net benefit to the overall economy.

Still, it feels good to pay less for something that you must buy on a regular basis, and it doesn't hurt that we are sending fewer of our dollars to oil producers abroad.

Earlier I said that it was difficult to find attractive investments today, and I also said that making predictions was folly. Countering both thoughts, I will nevertheless venture a sort of prediction: if WTI oil hits $45 there may very well be a good buying opportunity in oil stocks. It will surely not be a road without bumps, but over a longer term it is likely to prove to be very rewarding. We will keep our eyes and our minds open.

I wish you a Happy, Healthy and Prosperous New Year.

Jim Pappas