Our Take on the Fourth Quarter

This year has defied expectations. After the U.S. stock market's 30% rise in 2013, it might have been safe to assume that equities were going to take a bit of a breather this year. Instead, the broad-based Morningstar US Market Index rose another 12%, tacking on nearly 6% in the fourth quarter alone. On the fixed-income side, most investors were expecting this to be the year in which Treasury rates began to rise. Instead, yields on the 10-year Treasury bond fell from 3% to 2.2%.

Oil prices were in sharp focus during the fourth quarter. Crude started the quarter at more than $90 a barrel and ended at less than $53. This precipitous decline was driven by both concerns of oversupply in the market and weakening global demand. OPEC's decision to not cut supply accelerated the fall. Russia's economy was hit especially hard by the decline, and the ruble fell precipitously in the quarter after the country's central bank's emergency rate increase failed to stem the tide.

Geopolitical concerns in the quarter, ranging from the continued conflict in the Middle East to Ebola worries in the U.S. and renewed worries over the stability of the Greek government and its impact on the eurozone, created some waves in the quarter, but failed to halt the market rally.

The gap between a stronger U.S. economy and the weaker economies of other developed nations seemed to widen in the fourth quarter. In the U.S., job growth looked good as there were signs that lower gas prices were starting to spur consumer spending. Third-quarter GDP was revised upward to a 5% gain--a pace Morningstar's director of economic analysis Bob Johnson thinks is unsustainable. Still, he expects GDP to grow at a 2% to 2.5% range for the full year. In contrast, Europe's economy remained quite sluggish throughout the quarter, as fears of too low inflation and slow growth remained quite pronounced. Japan also struggled to find its footing, sliding back into a recession after a sales tax hike put a dent in consumer spending. Emerging markets, particularly China, also showed signs that growth was slowing down in the quarter.

The market anxiously watched this quarter to see what central bankers would do in response to this mixed economic picture. The Federal Reserve ended its quantitative-easing program in October, as was broadly expected. Equity investors cheered the bank's statement that it would be "patient" before raising rates, reducing fears that the bank would raise rates early in 2015 against the backdrop of a strong U.S. economy. The Fed is still broadly expected to raise rates sometime in the year. The European Central Bank laid the ground work for easing programs to keep deflation at bay, and that bank seems poised to begin an asset purchase program sometime in early 2015.

Merger and acquisition activity continued in the last part of the year as companies continued to seek strategic partnerships. Two of the biggest announced deals were the combination of oil-services firms

Sector-by-Sector Performance All but two stock sectors gained in the fourth quarter. Utilities and real estate, both up around 15%, were the best performers during the last 13 weeks. The consumer-defensive (up 10%) and consumer-cyclical (up 9%) sectors were the next-biggest winners. Energy was the clear loser, falling nearly 12% on the oil price slide. Basic materials (down 1%) was the other sector to lose ground. For the full year, only the energy sector (down 8%) lost ground. Real estate was up over 30% in 2014, while utilities nearly hit that mark. Health care and technology also saw gains of more than 20%.

Despite the stock market's strong performance in the quarter, valuations haven't changed much due to rising earnings. The median price/fair value ratio of all stocks covered by Morningstar analysts started the quarter at 1.00 and ended at 1.04. Morningstar StockInvestor editor Matt Coffina wrote in his market outlook that other measures of valuation, such as the Shiller P/E ratio, remain elevated but down slightly from the third quarter.

Real estate (up 15%) was the best-performing open-end sector fund category in the quarter. Health (up 10%) and consumer cyclical (up 8%) were the next-biggest gainers. Equity energy brought up the rear, losing 20%. Equity precious metals (down 13%), natural resources (down 13%) and energy limited partnerships (down 9%) were the other decliners. For the year, real estate (up 30%) and health (up 28%) were the big winners, with equity energy's 16% decline placing it last.

The India-equity category (up 5%) continued its winning streak in international open-end funds. The category is now up more than 40% for the year, blowing away the second-biggest gains for the year, Pacific/Asia ex-Japan, which was up more than 5%. Latin America stock, which lost more than 12% in 2014, was the worst-performing category in the quarter and for the year.

The decline in rates over 2014 helped boost many taxable-bond fund categories. In the quarter, long government (up 7%) was the best performer, followed by long-term bond (up 4%) and preferred stock (up 2%). Emerging-markets bond (down 4%) and high-yield bond (down 2%) were at the bottom of the heap. For the year, long government (up 21%) was also the biggest gainer while emerging-markets bond's less than 1% decline made it the only category in the red.

All data as of 12/30/2014