December 2014 Market Update

The year 2014 ended with the S&P 500 Index at 2058.90, less than1% below its all
time high of 2092.70, reached four days earlier. Most serious market analysts
believe the S&P 500 is a better gauge of the market than the Dow Jones 30
Industrials, which ended 2014 at 17,823, also less than 1% below its all time high of
18,103, also reached on 26 December. The dividend yield on the S&P 500 is 1.87%,
which is considerably lower than the historic average, though not as low as was
seen during the dot com boom period around 2000.
The yield on the US ten year treasury note ended 2014 at 2.17%. It fell fairly
steadily during the year from a level of 3% at the end of 2013. This is the most
widely watched bond yield and is also the base for which most mortgages are
priced. It had never been below 2% going back to the 19 th century, but pierced that
barrier in September 2011 and has averaged about 2% since then, though has been
between 2% and 3% since May 2013.
The US economy is healthy, with GDP having increased at a 4.6 rate during the April
June 2014 period and a 5.0% rate in the July September 2014 quarter.
Employment reached an all time high of 140 million, after being below 130 million
at the end of 2009. The unemployment rate fell to 5.4% after being over 9% at the
end of 2009.
Stock prices typically fall at a rate much faster than the overall economy when a
recession occurs, and this was the case in the most recent one, with the S&P 500
dropping from 1526 in June 2007 to a trough of 676.5 in March 2009, a decline of
over 55%. Conversely, stock prices usually rise at a much faster pace than the
overall economy when a recovery is underway, and this is also what has happened
recently, with the S&P 500 over triple its level of the 2009 low. My belief is that
stock prices are now so high that returns over the next decade are likely to be
disappointing, probably no more than 2-3%. For that reason, I advise holding a
lower percentage of stocks than usual.
It is quite difficult to predict the direction of interest rates, as witness the WSJ poll of
economists in December 2013 showing an average of 3.52% for the ten year T-note
yield at the end of 2014. With the yield at 2.17%, compared to the 100 year low of
1.46% and high above 15%, it cannot decline much more, though I must mention
that all treasury yields in Germany are less than zero for maturities of 5 years and
less. A ten year bond with a coupon of 4% would lose 8.3% of its value if interest
rates went up 1%, so it would take about two years to break even if rates changed
no further. . A five year bond with a coupon of 3% would lose 5.7% of its value if
interest rates went up 1%, so it would again take about two years to break even if
rates changed no further.
My two fund portfolio that is 70% stocks and 30% bonds was up 11% in 2014 and
up 114% since December 1999, for a 15 year annualized rate of return of 5.2%. My
two fund portfolio that is 50% stocks and 50% bonds was up 9.5% in 2014 and up

129.5% since December 1999, for a 15 year annualized rate of return of 5.7%. The
Vanguard 500 Index fund was up 13.5% in 2014 and up 84% since Dec. 1999. The
Vanguard Total US Market Index fund was up 15.5% in 2014 and up 127% since Dec.
2000 (it did not exist in 1999).
Note that these returns include the fund expenses and are not based on an index,
which would not be investible.