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Quarterly Market Update

Equity Outlook

Corporate Earnings Outlook Remains Positive

Solid earnings reports coming out of companies helped to prevent the October pullback from reaching a textbook correction stage as investors, encouraged by the earnings numbers, bought on the dips.

Domestic equities rewarded investors yet again in 2014 as the Dow Jones Industrials Average and the S&P 500 Index reached one record high after another in the fourth quarter. The Dow was up for the sixth year in a row, the S&P for the third. Continued improvement in the U.S. economy relative to that of the remainder of the world drove the performance of large caps and U.S. oriented stocks.

The advance was not without a few stumbles as stocks pulled back several times during the year. After posting its largest percentage gain of the year in early October and its largest daily point gain since 2011, the S&P 500 Index narrowly dodged a textbook correction in October after economic uncertainty and general volatility punished stocks. The volatile period lasted for only a couple of weeks, but the pullback was meaningful relative to what the stock market has seen in a long time, effectively removing some of the fluff, and propelling the market to a strong finish for the year.


Equity Chart 1

Figure 1. Broad markets continue to post double-digit returns for the one- and five-year periods.


Small caps surged in the fourth quarter, outperforming their mid- and large-cap brethren across both growth and value investment styles. Mid-cap stocks also outperformed large-cap stocks across both growth and value investment styles during the quarter. For the year, large-cap stocks outperformed both small and mid caps, except for mid-cap value stocks which were the year’s top performer.

The best performing sector in the S&P 500 Index was utilities, up over 24% for the year. Utility companies benefited from declining interest rates as most utility companies pay a higher dividend. Utility companies were also tremendous beneficiaries of lower energy prices which significantly reduced their input costs. Healthcare stocks did well as demographics continue to support this sector. In an environment where there is not tremendous economic growth, investors are looking for areas which are exhibiting consistent growth, and this can typically be found in both the healthcare and information technology sectors. It would be difficult to find a financial stock that is anywhere near today where its price was 5 years ago, and the financials sector continued to recover from the 2008 financial crisis. The energy sector was the obvious loser last year, down almost 10%, after crude oil prices plummeted.

Corporate Earnings Double the Initial Estimate

Corporate earnings were better in the third quarter and for 2014 overall than was anticipated going into the year, which partially explains why domestic stocks did so well. Going into the reporting season, earnings were expected to be up some 4-5% year- over-year. Once fully reported, earnings were up 9.2%, about double the initial estimate. The October stock market pullback came in the first week or so of the month, right at the start of the third-quarter earnings reporting season. The solid earnings reports coming out of companies helped to prevent the pullback from reaching a textbook correction stage as investors, encouraged by the earnings numbers, bought on the dips.

One characteristic of the third-quarter earnings season was that decent, modest revenue improvement supported results after an extended period of earnings growth driven by cost-cutting measures. We hope this trend of improving revenue growth will become more prevalent as the U.S. economy continues to gain strength. Margins were also better than expected as a result of this modest revenue growth. Companies are very lean as a result of their aforementioned cost management and the 4.0% revenue growth brought improved margins during the quarter.

Emerging and Developed Markets Abroad Struggle

Abroad, Japan slipped back into recession while the Eurozone threatened to do so, and China’s powerful growth engine slowed. Emerging and developed international stock markets lagged that of the U.S. Although the returns in local currency terms for most of the underlying countries that constitute the MSCI EAFE and MSCI Emerging Markets Indexes were up low single-digits for the year, once translated for U.S. dollar exposure, 2014 was a negative year.

Consumers Benefit from Lower Prices at the Pump

The two largest surprises of the year were the continued decline in interest rates and the plummet in crude oil prices. The latter should be a net positive for the economy as lower fuel costs will have a dramatic impact on household budgets acting like a “tax cut” for the American consumer. The other side of the equation will be the reduction in capital expenditure budgets of energy companies, but because more than two-thirds of the economy is driven by consumer spending, in our opinion, the drop in prices will be a net positive as 2015 unfolds.


Equity Chart 2

Figure 2. A comparison of price-to-earnings ratios and earnings-per-share across capitalizations for developed and emerging markets.


Outlook

A big wildcard in 2015 is whether or not the European Central Bank can pull together and effectively execute some type of quantitative easing program similar to what the Fed did here in the U.S.

Earnings growth should be the key to another year of positive performance for the U.S. equity market in 2015. As we expect the U.S. economy to continue to gain traction, revenues and earnings should follow suit, allowing equity prices to maintain their upward trend.

As a result of our expectation for an improving U.S. economy, we will maintain our current focus in client portfolios on large cap, U.S. equities. However, we are mindful of the tremendous flows into large cap and S&P 500 index funds. While it is not hard to argue that the U.S. economy is the best in the world right now, we continue to fully diversify our portfolios. We do not want to be caught in a one- sided trade, from either a diversification or a valuation standpoint.

We have a slight overweight to small caps for 2015. Small caps rely on foreign sources for approximately 18% of their revenues making them very U.S. centric in their business and earnings, which should bode well for their performance going forward. It is difficult to argue that small caps are cheap from a valuation basis, trading at a forward P/E of 29, but they are poised to do well given the strengthening U.S. economy.

We anticipate stock market volatility will pick up relative to 2014, after years of lower than average volatility. Investors must remember that volatility has been nearly absent from the equity markets, and we are just now beginning to approach normalized levels.

It is quite likely that it will take several months of evidence of consumer spending picking up as a result of the enormous drop in gasoline prices before the debate will be settled that the drop in oil will be a net positive for the economy. The negative impact from the cut back in capital expenditure budgets of industries dependent on oil is more immediately visible than the positive impact of the consumer having more discretionary income to spend. We expect the positive aspects of this dynamic to play out in both the economy and equity market as 2015 progresses.

A big wildcard in 2015 is whether or not the European Central Bank (ECB) can pull together and effectively execute some type of quantitative easing program similar to what the Fed did here in the U.S. We are maintaining our exposure to international equities for their diversification benefits as well as for our expectation that the ECB will be successful in its efforts to develop and execute an asset purchase program to satisfy the markets and jump start the Eurozone economy.

The other big wildcard revolves around the timing and magnitude of the Fed’s impending, rate-rising cycle. Investors are experiencing a great deal of anxiety in anticipation of the first rate hike and what it might do to the economy and equity market. We are confident that as our Fed takes another step back from its accommodative monetary policy, the ECB, Bank of Japan and other central banks throughout the world will fill the void that results, helping to stimulate the world economy.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).