Photo Credit-WSJ.com

What a predictable and very unpredictable year 2014 was. Yet, that could be said about every year!

For starters, the U.S. economy picked up steam throughout 2014, and the S&P 500 Index racked up another double-digit gain following 2013’s 30% advance. The economic forecast was reasonable. Though a call for another double-digit advance may have seemed to be a bit of a stretch, solid market fundamentals have yet to abate – more in a moment.

Still, who would have forecast utilities, which are normally a defensive sector, would lead the way if the S&P 500 Index had posted a double-digit gain? Credit the higher dividends they offer and falling bond yields.

Speaking of bond yields, there has been the rally in Treasury bonds and high-grade corporate debt. Weren’t we supposed to see a continuation in the upward drift in bond yields? At least that was the consensus.

It’s Exhibit A as to how markets can and do baffle the best minds. It’s also highlights why diversification among and between asset classes is such an important principle to successful long-term investing.

Finally, few could have predicted the outright collapse in oil prices. We began the year near $100 per barrel and ended just north of $50 per barrel. When and where oil will stabilize is anyone’s guess, but the decline in crude is responsible for the 10% drop in the S&P Energy sector. It was the worst performing of the 10 industry groups that make up the S&P 500 Index.

Source: Wall Street Journal, MSCI.com  *Annualized  **USD

The galloping bull

There were times when we hit a patch of volatility.  October quickly comes to mind. But the fundamentals quickly re-asserted themselves, driving stocks to new highs. These included:

1.  An acceleration in economic activity, which led a pickup in earnings growth. S&P 500 earnings improved from a modest increase of 5.6% in Q1 to a solid 10.3% by Q3, according to Thomson Reuters.

2.  A pledge by the Fed to keep short-term interest rates at rock bottom levels for a “considerable time.” Without drowning you in the tedious details of discounted cash flows, low interest rates provide little in the way of formidable competition for stocks.

3.  Stock buybacks by corporations continue to rise. According to S&P Dow Jones Indices, combined dividend and buyback expenditures set a new record of $892.66 billion for the 12 months ended September 30, with stock repurchases representing 62% of the total. Stock buybacks reflect confidence as well as real demand for shares.

Jeremy Siegel noted at year’s end, “The last three, four years, I thought this was easy. I mean, it was a slam dunk. The market was so undervalued with the interest rates so low, and earnings momentum going up. … Earnings momentum is going up, but we are closer to fair market value.”

Siegel is often a featured guest on CNBC and other national news outlets and is a professor at the highly-respected Wharton School of Business.

Siegel projected this time last year that the Dow Jones industrials would hit 18,000 by the end of 2014; the index cracked that milestone on December 23. Of course, it’s easy to be a Monday morning quarterback when you’ve accurately called the game, but his analysis is spot on.

Looking ahead, Siegel sees 20,000 on the Dow as a possibility, but he’s quick to point out, “We’re close to fully valued…it gets hard.”  His reasoning, “Interest rates are going to be…lower than what the Fed thinks…going forward.”

Before we get carried away with unbridled enthusiasm, it’s fair to point out that Siegel was relatively bullish on stocks as part of a panel discussion that was published by Business Week in May 2000.

And it highlights why I never pass up a moment to preach diversification between and among asset classes. No one has a crystal ball. No one can accurately foresee the unexpected events that may derail the most thoughtful forecasts.

A sneak peek at 2015

The fundamentals that have fueled equity gains in recent years remain in place. Even as the Fed ended its controversial bond-buying program last October, the fed funds rate is expected to remain at historically low levels through at least the end of 2015 and possibly beyond.

Moreover, the European Central Bank continues to hint that a more ambitious plan is in the works, as it battles a severe disinflationary environment. Simply put, central bank generosity has historically been a tailwind for stocks.

But as I already cautioned, let’s not get carried away. Let’s keep a balanced approach. Let’s adjust our approach when changes in your personal situation or goals make our current stance less than optimal.

While strong fundamentals remain in place, risks never disappear, even in a diversified portfolio. We can manage but not eliminate risk. So that leads to the next question – what may be some of the events that could create volatility in 2015.

1.  The year ended with oil near $50 per barrel. I recently saw a story in Reuters that noted $150 billion in energy projects around the globe face the axe. That means there will be winners and losers at current prices, though the net gain to the economy should be positive.

Meanwhile, Russia is undergoing a wrenching adjustment, as its energy-dependent economy must adapt to the new reality. The Russian ruble has fallen sharply this year, and Russia’s central bank said its economy could shrink by as much as 4.7% in 2015 if oil averages $60 a barrel.

A 1998-like crisis that briefly walloped stocks doesn’t appear to be on the horizon, but any contagion that seeps out of Russia could create volatility at home.

Then there has been the steep selloff in junk bonds tied to the energy sector. While Treasury and investment grade yields fell last year, high-yield debt rose. Some of the rise can be blamed on expectations the Fed will eventually raise interest rates, which could crimp some highly-leveraged borrowers.

But a big part of the increase can be blamed on default fears in the energy patch amid a re-pricing of risk in high-yield energy bonds. If concerns were to seep into other sectors of the junk bond market, we could see a spillover into stocks.

2. One test the market faces early this year: Greece is set to elect a new president in January, and there are worries the far left could take the top spot.

While political leaders on the left favor staying in the euro-zone, they want to renegotiate the terms of the Greek bailout. Markets rarely enjoy grappling with an added layer of uncertainty.

3.  Slowing growth in China and Europe’s tepid recovery could dampen growth at home. Odds are fairly low as the U.S. simply isn’t dependent on overseas demand to drive its economy. So far, U.S. growth has accelerated in the face of global jitters.

4.  Will we get volatility around the Fed’s first rate hike in nearly a decade? There are no guarantees when it comes to Fed policy, but if U.S. employment and economic growth continues at the current pace, the Fed has signaled rates will start rising in 2015. Although it is doing its best to telegraph its intentions, markets could get jittery in the interim.

5.  Emerging market anxieties. A stronger dollar and a Federal Reserve that is expected to begin raising rates could pressure developing countries that have sold bonds in greenbacks instead of their local currencies, forcing them to repay loans in more expensive dollars. Foreign reserves (akin to a rainy day fund) could minimize any pressure, but it’s something that bears watching.

6.  Liquidity is like oxygen to the market. A brief surge in U.S. Treasury prices and the steep but short-lived stocks selloff in October can be partly blamed on a temporary lack of liquidity. Some cite well-intentioned regulations put in place after the 2008 financial crisis.

7.  Cyber-attacks. North Korea’s alleged attack on Sony quickly comes to mind. It’s impossible to forecast, but the outside chance of a big event can’t be completely discounted.

8.  Geopolitical fears. War or geopolitical instability has historically caused short-term losses. Whether the Arab spring, Russia’s incursion into Ukraine, or the rise of ISIS (ISIL) in Iraq, heightened uncertainty is not a friend of investors.

Bottom line

I always stress the importance of being comfortable with your portfolio. As we’ve talked about in our meetings, my goal is to help you mitigate that risk. But you must be comfortable with the level of risk you’re taking as we set out to meet your objectives. If you are not, let’s talk and recalibrate.

Stick to the plan. Markets rise and markets fall, but unless there have been changes in your circumstances or you’ve hit milestones in your life, such as retirement, stay with the plan. By itself, a record high in stocks isn’t a good reason to bail out of stocks.