The U.S. economy is entering the new year with a head of steam, riding high on rapid economic growth, positive consumer sentiment, falling energy prices and an improving labor market.  In December, the Commerce Department reported that in the third quarter the U.S. economy expanded at a rate of 5%, the fastest rate in eleven years.  The labor market continues to improve, with the unemployment rate now at 5.6%, the lowest it has been since June 2008.  The U.S. economy added 2.95 million jobs in the last year, making 2014 the best year for U.S. job creation since 1999.  Consumer sentiment is also improving.  The Thomson Reuters/University of Michigan final reading on consumer sentiment for December was 93.9, the highest reading in eight years.  The above data show the U.S. economy to be reasonably healthy and doing significantly better than the global economy at large.

There was a wide disparity in the performance of various asset classes in 2014.  Large-cap U.S. stocks led the way higher, outperforming small-caps by a wide margin (a role reversal from 2013).  The Dow Jones Industrial Average gained 7.5% while the S&P 500 Index gained 11.4% (Including dividends, the S&P was up 13.7%.)  U.S. small-cap stocks posted positive but lackluster returns.  The Russell 2000 Index of small companies was up 3.5% for the year.  International markets mostly disappointed U.S.-based investors in 2014 due in large measure to the strength of the U.S. dollar versus other major currencies.  The Dow Jones World Index (excl U.S.) was down 5.5%.  Bonds did surprisingly well, delivering positive returns despite the very low interest rates. Yields, in a surprise to many market forecasters, dropped significantly in 2014.  The 10-year U.S. Treasury note began the year yielding 3% and ended it yielding 2.17%.

The two biggest surprises in financial markets in 2014 were the crash of oil prices in the back half of the year and falling interest rates.  Oil reached a high of $107 per barrel in June 2014 before plummeting to $53 by year end on the back of continued supply growth (particularly here in the U.S.) and slowing global economic growth.  How many analysts predicted such a sudden vertiginous drop?  Not a single one, as far as I know.  In fact, as recently as March Chevron’s CEO said “the $100 barrel is the new $20 barrel”.

Oil producing countries are now in a war for market share, and the lower-cost producers in the Organization of Petroleum Exporting Countries (OPEC) are intent on driving prices so low that they force much higher-cost production (such as U.S. shale oil) to cut their production and thereby reduce supply.

While falling oil prices would have been unambiguously positive for the U.S. economy in 1975, the picture is much different in 2015.  Energy production is now a much more important industry in the U.S. and has contributed significantly to job growth in recent years.  Lower oil prices will idle many rigs and force many layoffs.  The positive side of lower prices, of course, is that both consumers and corporate users of energy will receive what is in effect a large tax cut.  The Department of Energy estimates that the average household will save $750 in 2015 due to lower gasoline prices.  U.S. companies stand to save plenty as well.

Another very important trend during 2014 was the rising strength of the dollar.  For the first year this century, the dollar in 2014 gained value relative to all other major world currencies.  The dollar index, which measures the dollar against a group of other major currencies, hit a nine-year high in the last week of 2014.  While the strong dollar will help the purchasing power of domestic U.S. consumers and business who purchase foreign goods (and global commodities such as oil and copper), it will work against U.S.-based multinationals that are trying to sell their goods and services to overseas buyers.  With the U.S. economy doing very well, the Fed may be forced to begin raising rates later this year.  If higher rates do materialize this year in the U.S., the greenback could be poised for further gains in 2015. (All else equal, global investors prefer to own currencies that have higher yields.  Right now U.S. 10-year yields are 1.82% while Germany’s are 0.43% and Japan’s are 0.25%.)

Equity markets, very volatile in the first few trading days of the year as they cope with still falling oil prices and whiffs of deflation coming out of Europe, have both headwinds and tailwinds buffeting them as we move into 2015.  Headwinds for U.S. stocks include newly higher valuations, the prospect of rising interest rates if the economy continues to improve, and slowing growth overseas that will eventually impact U.S. growth. Tailwinds include much lower energy prices, an improving labor market and the consequential improvement in consumer sentiment.

All in all, a robust U.S. economy, a strong dollar, lower oil prices, still-low interest rates and a stable labor market continue to provide a firm foundation for U.S. equities.  While U.S. equity valuations are slightly (10%-20%) elevated from historical average levels, given the low bond yields worldwide and the more challenging economic conditions outside the U.S., it would not be a huge surprise if they hold these valuations for some time, as they must be compared to the milieu of other investments available to global investors.