Markets start the year on a down note

After a 2014 with few declines, none of them sustained, U.S. stock markets dropped across the board in January, as investors reassessed their risk tolerances. Driven by unexpectedly slow earnings growth, caused in part by the strong dollar and in part by economic weakness elsewhere in the world, the S&P 500 Index was down 3 percent and the Dow Jones Industrial Average fared even worse, losing 3.58 percent. The Nasdaq did slightly better, posting a 2.13-percent decline.

In a reversal from last month, international markets were the better performers in January. Developed international markets, represented by the MSCI EAFE Index, showed a gain of 0.49 percent for the month, while the MSCI Emerging Markets Index was up 0.55 percent. Part of the discrepancy in returns compared with domestic markets is that, although U.S. corporate earnings have suffered from the strong dollar, companies from Japan and Europe, where the currencies have weakened, have benefited from it.

Another interesting point about this discrepancy is that the gains in international markets took place as political risks were rising in many areas, particularly in Europe. The Greek election has led to a growing confrontation between that country and Germany, fueling speculation that a repeat of the 2011 crisis is possible.

The strong dollar was not the only factor driving the loss in U.S. markets. A contributing factor was concern about the future profitability of U.S. companies. Per FactSet, as of January 30, analysts have actually projected an earnings decline for companies in the S&P 500 for the first quarter of 2015. Much of this is due to drops in energy company earnings, but even outside the energy sector, earnings growth is down. With the market now richly priced, any reduction in earnings could have a negative effect on stock prices.

Technically, there are reasons for some concern. Both the Dow and S&P dropped below their 100-day moving averages, although they remain above their 200-day averages. The international indices are still below their 200-day moving averages, despite their recent improved performance, suggesting continued risk. Although none of this is necessarily a red flag, it suggests that investors should exercise caution.

Fixed income benefited from the weak month for stocks and the rising risk perceptions. The Barclays Capital Aggregate Bond Index returned a solid 2.10 percent. This improvement was linked to a decline in the U.S. 10-year Treasury yield, which closed out January at 1.68 percent, down from 2.12 percent at the start of the month. The strong performance from fixed income underlined the diversification benefits that bonds offer, even when rates are at historically low levels.

U.S. economy remains strong despite slower growth 

Gross domestic product (GDP) figures for the fourth quarter of 2014 were not bad-with initial estimates putting growth at 2.6 percent-but this was a decline from the previous quarter's result of 5-percent growth. There were, however, statistical reasons to believe that the slowdown was less than it appeared, and economists largely adopted a wait-and-see attitude.

The major factors that led to the slower growth included a rise in imports and a drop in exports, largely attributable to the strong dollar; an adjustment to defense spending from an unrealistically high number in the previous quarter; and a drop in business investment, probably caused by oil companies pulling back. Overall, while fourth-quarter growth was somewhat disappointing, it seemed to be the result of several one-time factors, rather than of a sustained slowdown.

Other factors looked good. The December employment growth figure was strong, at 252,000, adding to the longest string of monthly gains over 200,000 since the 1990s. Further, more jobs were created in 2014 than in any year since 1999. Jobless claims remained low, and unemployment declined to levels that the Federal Reserve (Fed) considers normal, driving debate over when and whether the Fed will start to raise rates.

A significant positive factor has been the decline in oil prices. Lower prices at the gas pump have put more money in consumers' pockets, aiding consumer spending growth and consumer confidence. This is important, given that the consumer has historically contributed more than two-thirds to overall U.S. economic growth. Consumer confidence and many other economic indicators are at multiyear highs, and the composite index suggests continued growth.

Worries elsewhere 

While the U.S. continues to grow, the situation elsewhere is not as favorable. In Europe, in particular, growth has remained low and unemployment high, bringing current austerity policies under increasing political threat. Greece, one of the worst affected of the European countries, just had an election where the victors, the Syriza party, vowed to at least renegotiate the nation's debt and perhaps pull out of the eurozone. Greece was also at the center of the last European crisis.  

Although a compromise remains the most likely solution, markets have become increasingly skittish about the prospect of another European crisis.

In response to continued economic weakness and rising political risk, the European Central Bank launched a quantitative easing bond-buying program of its own, designed to stimulate growth and employment by lowering interest rates. Although this type of program worked for the U.S., it remains to be seen whether the politics of the various governments will allow it sufficient time to work in Europe.

Europe is not the only risk area. At the end of last year, Japan launched a quantitative easing program, for the same reason as Europe-to try to drive faster growth. The results, as with Europe, have been inconclusive so far on growth but have had the effect of making its currency less valuable-driving up the value of the dollar. Finally, China just reported its lowest growth rate in decades.

Although weakness elsewhere could hit the U.S. recovery, it also brings positive effects. For example, low interest rates, driven by central bank programs in Europe and Japan, support U.S. economic growth. In addition, U.S. asset prices benefit as foreign investors move wealth here in search of higher growth and a stronger currency. Finally, slower growth in other parts of the world keeps oil and commodity prices low, again to the benefit of the U.S.

Economic growth versus stock valuations

Even though weakness in other areas of the world benefits the real U.S. economy, it presents much more of a risk to domestic stock markets.

For example, as mentioned previously, one scenario that seems to be playing out is a slowdown in corporate earnings growth. With the start of 2015 expected to show an actual decline in earnings, anticipated growth levels for the year as a whole have to be considered at risk. The strong dollar is negatively affecting the earnings contribution of foreign sales, and continuing economic weakness is driving slow sales growth outside the U.S. Another good example is lower oil prices. Although this factor certainly benefits the economy over time, the negative effects on the revenue and earnings of energy companies are immediate and substantial.

With stock valuations still at high levels, a decline in earnings growth-or, worse, of the level of earnings-could very well lead investors to reduce their risk exposure, bringing valuations back down to a more normal level. This remains a major risk to stock prices at the start of 2015.

Good fundamentals still in place but stock valuations at risk

As we move through 2015, the economy should continue its recovery, with growth in employment bringing the economy back to normal levels. Strong fundamental factors, including the housing market, low oil and gas prices, and steady income and spending growth, should support a healthy economic environment.

At the same time, the weak performance of the U.S. stock markets so far this year suggests that investors may be reassessing their willingness to take risk and put capital to work at current valuations. Even though the long-term prospects for stocks remain potentially strong, it appears very possible that short-term weakness will continue. Offsetting this is the strong performance of traditional fixed income assets, as interest rates have declined.

The past month's events underscore the need for a diversified portfolio and maintaining a long-term perspective aligned with investor goals. The ongoing growth of the economy, which appears to be on track, should provide a cushion for any market adjustments in the short term, and proper diversification should further limit their effects on your portfolio. Longer term, cautious optimism remains the appropriate stance, as history has shown us that markets and economies consistently return to a growth path.

Authored by Brad McMillan, senior vice president, chief investment officer at Commonwealth Financial Network.