Financial markets 2015: earnings, government and the world.

• Author: Jennings, Robert

Last year, we predicted that the 2014 financial markets would be driven more by earnings than by concerns about whether the politicians could agree with each other. We guaranteed that 2014 would not be as good as 2013.

We were right. From November 20, 2013, to the same date this year, the S&P500 rose 13.7 percent from 1,805 to 2,053. This contrasts with the twelve months ending on November 1, 2013, where the S&P 500 rose a spectacular 25.5 percent. The rise in the S&P 500 was mimicked by similar increases in the Dow and the broad-based Russell 3000. All show that the stock market performed well, just not as well as the previous year. Still, the most recent year is well above the 7.5 percent average return over the past half century. We think average to below-average returns are the most likely scenario for 2015.

What factors are likely to drive the stock market over the next twelve months? We think it will be a combination of earnings and government. With valuation ratios near historic highs, the market appears to have little potential for increasing the valuation of companies other than what they produce by earnings. If anything, interest rates may drive valuations lower, but we forecast interest rates to be flat over 2015. As usual, government is likely to either hurt the market or be neutral.

The Washington dysfunction may prove neutral for investors. With Republicans now controlling both the House and Senate, an increase in taxes or spending is unlikely. With the economy growing, federal taxes are roughly 17.5 percent of GDP. As a result, the budget deficit fell from $608 billion in fiscal year (FY) 2013 to a projected $506 billion in FY 2014 (which ended in September). If we combine this fiscal policy with our forecasted 3 percent real GDP growth and 1-2 percent inflation, this is a relatively favorable environment for investors.

While the Obama administration has taken actions that undermine investor confidence in the past, such as tougher climate-change regulations, its attention appears to be focused on foreign policy (e.g., ISIS) and health policy (Ebola). It is unlikely that it will undertake major economic initiatives over the next year.

The Federal Reserve has backed off of quantitative easing (QE), but the policy is likely to be "dovish" in targeting interest rates rather than inflation. Bond buying is now an established part of the Fed's toolkit, especially with inflation forecasts being in the 1-2 percent range.

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