MONEY

The Most Amazing Thing About Apple? It Still Looks Cheap

Beats headphones are sold along side iPods in an Apple store in New York City.
Beats headphones are sold along side iPods in an Apple store in New York City. Andrew Burton—Getty Images

Despite another blowout quarter, Apple shares are still trading at less than 15 times earnings, which is a bargain for a top-flight tech company.

It’s hard to catch people by surprise when you’re already the center of attention. But with the help of strong holiday sales and another hit iPhone, that’s just what Apple did on Tuesday.

The Cupertino, Calif., gadget maker said sales jumped nearly 30% in its fiscal first quarter to a whopping $75 billion. Wall Street Analysts polled by Fortune had expected an increase of only 20%.

What’s remarkable is that, despite the hype, it’s not hard to make the case that Apple APPLE INC. AAPL 3.1133% shares, up about 8% to $118, are reasonably priced. Here’s our investment case:

The heart of the business: More than 90% of Apple’s revenue last quarter came from hardware sales—69% from iPhone sales alone. But if hardware is what Apple sells, it’s not what the company markets. “Apple’s main product is an experience,” tech analyst Neil Cybart told Money magazine last month. “They look at all of their products as taking away the complicated part of technology so the users can feel like they have more control over their lives.”

Apple aims to build a world in which you’ll own Beats by Dr. Dre headphones, wear an Apple Watch, buy coffee with the Apple Pay payments system, and make hands-free phone calls via Apple CarPlay. With all those products interlinked and running on Apple’s iOS software, you’ll rely on the ecosystem for daily tasks, making it a hassle for you to buy your next phone or tablet from anyone other than Apple.

So what’s the risk? Apple has a hit with the iPhone 6 and 6 Plus, in all selling 74 million smartphones last quarter. Indeed, as TIME recently reported, the iPhone 6’s success has cut into Android’s smartphone market share in the U.S. for the first time since September 2013.

But the company isn’t particularly good at ­enticing the owner of one Apple product to purchase another, says Consumer Intelligence Research Partners’ ­Michael Levin.

For instance, only 28% of iPhone owners have an Apple computer, and less than half of them own a tablet, says CIRP. Sales for the iPad have fallen 22% over the past year, acknowledges Apple. But CEO Tim Cook, noting that the company has sold more than 250 million iPads over the past four years, told investors in October that he’s “very bullish on where we can take the iPad over time.”

Why it’s still a value: Apple enjoyed a banner year in 2014. Spurred by sales of the latest iterations of the iPhone and anticipation of the Apple Watch’s release in April, the company’s stock has risen nearly 50% since the start of 2014.

Despite that gain, Apple’s price/earnings ratio, based on projected profits, is just 14. That means the stock trades at an 11% discount to the S&P 500 technology index, even though the company’s earnings are growing 32% faster than the average big tech stock’s.

Apple’s low valuation stems from factors such as investors’ doubts that a company its size can grow as fast as smaller tech firms, along with uncertainty that Apple will keep making products that are both popular and profitable.

That said, Apple is still the best company by far at creating exciting technology that people want to buy. Plus, signs point to an ever-increasing dividend from the stock, which now yields 1.6%; a larger payout can be easily covered by Apple’s $178 billion cash reserves.

This story is adapted from Apple, Amazon, or Google: Who Will Win the Battle of the Tech Titans? in the 2015 Investor’s Guide in the January-Feburary issue of MONEY

MONEY Tech

Microsoft Takes a Step Down the Mobile Path

Microsoft and Nokia sign
Lehtikuva Lehtikuva—Reuters

The onetime technology leader now finds itself struggling to compete in mobile and media markets. With a new operating system set to debut this week, it’s looking to strengthen its chances.

On Wednesday, Microsoft is set to unveil Windows 10, the newest version of its flagship operating system. The time has come, the company says, to introduce a “new Windows…built from the ground up for a mobile-first, cloud-first world.” Most critically, the new products will make it easier for developers to build apps for mobile devices, including Microsoft’s own smartphones.

The news couldn’t come a moment too soon. The onetime technology leader has been struggling to compete in mobile and media markets. Currently, Windows models account for less than 5% of phones in use. So while Microsoft wants to be seen as the fourth member of the current pack of tech titans, alongside Apple, Amazon, and Google, it still has a ways to go.

Mobile weakness notwithstanding, Microsoft remains the world’s largest software producer, with a stock market value of $381 billion (north of Goo­gle’s) and $90 billion in cash on hand. Revenue from selling and licensing products like Windows to companies—about half of Microsoft’s business—grew by an impressive 10% last quarter. Revenue from Xbox, one of the world’s most popular gaming consoles, grew more than 58%. Meanwhile, the company released its latest cellphone to positive reviews. The stock stands at a near 15-year high.

Still Facing Headwinds

A lot is riding on the success of Windows 10. Demand for personal computers has fallen off, thanks to smartphones and tablets. Sales of Microsoft’s own tablets, such as the Surface Pro 3, have picked up recently but lag far behind those of the Kindle Fire and iPad.

The company’s smartphone—$600 at its most expensive—is “too high cost, and it’s too late,” says Mary Mona­han of research company Javelin. A tardy entrance gave Google and Apple valuable lead time and made Windows a less desirable outlet for app developers. “The value of the iPhone is that you get all of these great apps,” says Monahan. “When you buy a Microsoft phone, what do you get?”

The Outlook for Investors

Prospects for Microsoft aren’t ugly, but they’re not great either. While Xbox, with its legions of dedi­cated customers, has proven popular, analysts believe long-term success requires an untethered platform. “The future is more control of your day-to-day life with your phone,” says Monahan.

Windows 10 is part of new chief executive Satya Nadella’s strategy to prioritize investments in mobile, like its 2014 purchase of Nokia’s handset division; Microsoft is likely to use its cash kitty to fund further deals.

Microsoft’s forward price/earnings ratio is near Apple’s, and it has a higher-than-average dividend yield: 2.7%, vs. 1.6% for its information-technology peers. That means investors are paid well to hold the onetime personal computing champion and wait for a turnaround. With the release of Windows 10, that reversal may be one step closer.

Read Next: Who Will Win the Battle of the Tech Titans?

MONEY Economy

The Doom and Gloom of Deflation Hasn’t Reached Our Shores—Yet

Cars fill up at the pumps at a Shell station near downtown Detroit, where the sign shows the price at $1.899 a gallon on Thursday, Jan. 1, 2015
Cars fill up at the pumps at a Shell station near downtown Detroit, where the sign shows the price at $1.899 a gallon on Thursday, Jan. 1, 2015. AAA Michigan said that the average cost of self-serve unleaded gasoline in the state was $1.97 a gallon, the first time the price has fallen below $2 a gallon since March 2009 and down 9 cents since the beginning of the week. David N. Goodman—AP

A new government report shows that prices are clearly falling, mostly due to sinking energy prices. Even so, this could keep the Fed from hiking rates for months.

You might think that falling consumer prices would be met with cheers on Wall Street, especially in the all-important holiday shopping season.

But when a new government report released on Friday showed that consumer prices in December had declined by the largest amount in six years, there was a bit of a gasp on Wall Street.

The Labor Department reported that the Consumer Price Index, perhaps the most widely followed measure of U.S. inflation, sank 0.4% in December, after dropping 0.3% in November.

This data clearly shows there is no inflation in this economy.

Yet it’s still too soon to say if there’s deflation — a quagmire that Europe is currently stuck in, where prices keep falling to the point where consumers postpone purchases, further weakening the economy.

Why?

For starters, over the past 12 months, prices in general have inched up 0.8%. While that’s the lowest yearly rate since 2009, it’s still positive.

More importantly, plummeting gasoline prices were the real culprit that drove CPI down in December and November, notes Michael Montgomery, U.S. economist for I.H.S. In fact, last month’s 9.4% decline in gas prices accounted for the entirety of the 0.4% decline in CPI, he said.

And keep in mind that several key categories of spending did rise in December, including food, electricity, and housing costs.

Overall, so-called core CPI — which strips out volatile energy and food costs — was flat last month and rose 0.1% in November.

This helps explains why Americans regard falling prices as a blessing so far — not a curse.

Consumer confidence, as measured by the University of Michigan’s consumer sentiment index, jumped to a reading of 98.2 this month, the highest point since January 2004.

But economists expect the deflation concerns to linger, as gas prices have sunk even faster this month than in December.

Already, there’s talk that the Federal Reserve might hold off raising interest rates this year because the global slowdown in general and Europe’s deflation specifically are keeping inflation at bay here at home.

This chatter—and concern—will grow if January’s CPI figures show even more falling prices.

MONEY stocks

China’s Boom Is Over — and Here’s What You Can Do About It

Illustration of Chinese dragon as snail
Edel Rodriguez

The powerhouse that seemed ready to propel the global economy for decades is now stuck in a period of slowing growth. Here’s what that means for your portfolio

Every so often an investment theme comes along that seems so big and compelling that you feel it can’t be ignored. This happened in the 1980s with Japanese stocks. It happened again with the Internet boom of the 1990s. You know how those ended.

Today history appears to be repeating itself in China.

Just a decade ago, China was hailed as the engine that would single-handedly drive the global economy for years to come. That seemed plausible, as a billion Chinese attempted something never before accomplished: tran­sitioning from an agrarian to an industrial to a consumer economy, all in a single generation.

Recently, however, this ride to prosperity has hit the skids. A real estate bubble threatens to crimp consumer wealth; over-investment in a wide range of industries is likely to dampen growth; and the transition to a developed economy is stuck in an awkward phase that has trapped other emerging markets.

No wonder Chinese equities—despite a strong rebound last year—are down around half from their 2007 peak.

iSCH1

Like the Japan and dotcom manias before it, China looks like an old story. “Do you have to be in China?” asks Henrik Strabo, head of international investments for Rainier Investment Management in Seattle. “The truth is, no.”

If you’ve bought the China story—and since 2000 hundreds of thousands of U.S. investors have plowed $176 billion into emerging-markets mutual and exchange-traded funds, which have big stakes in China—that’s a pretty bold statement.

In fact, even if you haven’t invested directly in Chinese stocks and simply hold a broad-based international equity fund, China’s Great Slowdown has an impact on how you should think about your portfolio. Here’s what you need to understand about China’s next chapter.

China Has Hit More Than a Speed Bump

After expanding at an annual clip of more than 10% a decade ago, China’s economy has slowed, growing at just over 7% in 2014. That’s expected to fall to 6.5% in the next couple of years, according to economists at UBS. And then it’s “on to 5% and below over the coming decade,” says Jeffrey Kleintop, chief global investment strategist at Charles Schwab.

Why is this worrisome when gross domestic product in the U.S. is expanding at a much slower 3%?

For starters, it represents a steep drop from prior expectations. As recently as three years ago, economists had been forecasting that China would still be growing at roughly an 8% clip by 2016.

The bigger worry is that the slowdown means that China has reached a phase that frustrates many emerging economies on the path to becoming fully “developed,” a stage some economists refer to as the middle-income trap.

On the one hand, a growing number of Chinese are approaching middle-class status, which means wages are on the rise. That sounds good, but rising labor costs chip away at China’s competitive advantage in older, industrial sectors. “You’re seeing more and more manufacturers look at other, cheaper markets like Indonesia, Vietnam, and the Philippines,” says Eric Moffett, manager of the T. Rowe Price Asia Opportunities Fund.

At the same time, the country’s new consumer-centric economy has yet to fully form. About half of China’s urban population is thought to be middle-class by that nation’s standards, but half of Chinese still live in the countryside, and the vast majority of those households are poor. Couple this with the deteriorating housing market—which accounts for the bulk of the wealth for the middle class—and you can see why China isn’t able to buy its way to prosperity just yet.

This in-between stage is when fast-growing economies typically downshift significantly. After prolonged periods of “supercharged” expansion, these economies tend to suffer through years when they regress to a more typical rate of global growth, according to a recent paper by Harvard professors Lawrence Summers and Lant Pritchett.

In some cases, like Brazil, this slowdown prevents the economy from taking that final step to advanced status. Brazil had been expanding 5.2% a year from 1967 to 1980, but that growth slowed to less than 1% annually from 1981 to 2002.

No one is saying China will be stuck in this trap for a generation, like Brazil, but China could be looking at a long-term growth rate closer to 4% to 5% than 8% to 10%.

iSCH2

Your best strategy: Go where the growth is—at home. A few years ago the global economy was ex­pected to expand at an annual pace of 4.2% in 2015, trouncing the U.S.  Today the forecast is down to 3.1%, pretty much the same pace as the U.S. economy, which is expected to keep accelerating through 2017.

In recent years, some market strategists and financial planners have instructed investors to keep as much as 40% to 50% of their stocks in foreign funds. But ­dropping that allocation to 20% to 30% still gives you most of the diversification benefit of owning non-U.S. stocks.

The Losers Aren’t Just in Asia

China’s rise to power lifted the fortunes of its neighboring trade partners too, so it stands to reason that a broad swath of the emerging markets is now at risk. “China is still the beating heart of Asia and the emerging markets,” says Moffett. “If it slows down, all the other countries exporting to and importing from China will see their growth prospects affected.”

The country’s biggest trading partners in the region are Hong Kong, Japan, South Korea, and Taiwan, and all are slowing down. Economists forecast that the growth rates in those four nations will slip below 3% next year.

Beyond Asia, “you have to be careful with the commodity exporters,” says Rainier’s Strabo. China’s slowdown over the past five years is a big reason commodity prices in general and oil specifically have sunk more than 50% since 2011.

China consumes about 40% of the world’s copper and 11% of its oil. As the country’s appetite for commodities wanes, natural resource producers such as Australia, Russia, and Latin America will feel the blow.

Your best strategy: Keep your emerging-markets stake to around 5% of your total portfolio. If your only foreign exposure is a total international equity fund, then you’re probably already there. If, however, you’ve tacked on an emerging-markets “tilt” to your portfolio to try to boost returns, unwind those positions, starting with funds focusing on Asia, Latin America, or Russia.

Here’s another bet that’s now played out: A popular strategy in the global slowdown was to take fliers on Western companies with the biggest exposure to China—companies such as the British spirits maker Diageo (think Johnnie Walker and Guinness) and Yum Brands (KFC and Pizza Hut)—solely because of their China reach. And for a while, that paid off.

Now, though, the stocks of Yum and Diageo have stalled, and major global companies such as Anheuser-Busch InBev and Unilever have reported disappointing results recently in part owing to subpar sales in China as well as in other emerging markets.

Demographic Problems Will Only Make Things Worse

For years, China’s sheer size was seen as a massive competitive advantage. Indeed, China has three times as many workers as the United States has people.

Yet as the country’s older workers have been retiring, China’s working-age population has been quietly shrinking in recent years. Economists say this will most likely lead to labor shortages over the coming years, putting even more pressure on wages to rise.

iSCH3

China’s demographic problem has been exacerbated by the country’s “one-child” policy, which has prevented an estimated 400 million births since 1979. But China isn’t the only emerging market suffering from bad demographic trends.

Birthrates are low throughout East Asia. The ratio of people 15 to 64 to those 65 and older will plummet from about 7 to 1 to 3 to 1 in the next 15 years in Taiwan, South Korea, and Hong Kong, dragging down growth.

Your best strategy: If you’re a growth-focused investor who wants more than that 5% stake in emerging markets, concentrate on developing economies with more youthful populations and more potential to expand. One fund that gives you that—with big holdings in the Philippines, Saudi Arabia, Egypt, and Colombia—is Harding Loevner Frontier Emerging Markets HARDING LOEVNER FRONT EM MKTS INV HLMOX -0.2301% . Over the past five years, the fund has gained around 7% a year, more than triple the return of the typical emerging-markets portfolio.

Another option is EGShares ­Beyond BRICs EGA EMERGING GLOBA EGSHARES BEYOND BRICS ETF BBRC -0.3074% . Rather than investing in the emerging markets’ old-guard leaders—Brazil, Russia, India, and China—this ETF counts firms from more consumer-driven economies, such as Mexico and Malaysia, among its top holdings.

The Parallels Between China and 1990s Japan are Alarming

For starters, China is facing a real estate crisis similar to Japan’s, says Nariman Behravesh, chief economist at IHS. With easy access to cheap credit, developers have flooded the major cities with excess housing. Floor space per urban resident has grown to 40 square meters, compared with just 35 square meters in Japan and 33 in the U.K.

Not surprisingly, prices in 100 top Chinese cities have been sliding for seven months. Whether China’s property bubble bursts or not, falling home values chip away at household net worth; that, in turn, drags down consumer sen­timent and spending, Behravesh says.

Other unfortunate similarities between the two nations: Excess capacity plagues numerous sectors of China’s economy, ranging from steel to chemicals to an auto industry made up of 96 car­ brands.

Also, Chinese officials face political pressure to focus on short-term growth rather than long-term fixes. This type of thinking has resulted in the rise of so-called zombie companies, much like what Japan saw in the ’90s. “These are companies that aren’t really viable but are being kept alive,” Behravesh says. Yet for the economy to get back on track, inefficiently run businesses have to be allowed to fail, market strategists say.

Your best strategy: Focus on the few major differences between the two countries. Unlike Japan, for instance, China is still a young, emerging economy. Slowdown or not, “the growth of the middle class will continue in China, and that will absorb some of the overhang in the economy, which is something Japan couldn’t count on,” says Michael Kass, manager of Baron Emerging Markets Fund.

What’s more, when Japan’s bubble burst in late 1989, stocks in that country were trading at a frothy price/earnings ratio of around 50. By contrast, Chinese shares trade at a reasonable P/E of around 10.

To be sure, not all Chinese stocks enjoy such low valuations. As competition heats up to supply China’s population with basic goods, valuations on consumer staples companies have nearly doubled over the past four years to a P/E of around 27.

At the same time, the loss of faith in the Chinese story means there are decent values in industries that cater to the established middle and upper-middle class, says Nick Niziolek, co-manager of the Calamos Evolving World Growth Fund. Health care and gaming stocks in particular suffered setbacks last year. And Chinese consumer discretionary stocks are trading at a P/E of just 12, down from 20 five years ago.

You can invest in such businesses through EGShares Emerging Markets Domestic Demand ETF EGA EMERGING GLOBA EGSHARES EMERGING MKTS DOME EMDD 0.2573% , which owns shares of companies that cater to local buyers within their home countries, rather than relying on exports. Chinese shares represent about 17% of the fund, led by names such as China Mobile.

That one of the world’s great growth stories is now best viewed as a place to pick up stocks on the cheap might seem a strange twist—until you remember your Japanese and Internet history.

MONEY stocks

Probability That Stocks Will Rise This Year: 90%

barometer
iStock

After a furious rally on Thursday, stocks are now up after the first five trading days of January—a time-tested signal the market could be in store for another positive year.

Maybe this will be a decent year for stocks after all.

After the Dow Jones industrial average lost around 500 points in the first three trading days of the year, it sure looked as if 2015 was getting off to a lousy start. But for the past two days, the Dow posted back-to-back triple digits gains. Yesterday alone, the Dow soared more than 300 points as investors calmed down about troubles in the global economy.

The result: The Dow is up 0.44%, while the Standard & Poor’s 500 index has gained 0.15% so far this year.

^SPX Chart

^SPX data by YCharts

What’s the big deal?

The first five trading days of the year — known as the January Barometer — offer a surprisingly good clue for how stocks are likely to perform for the full year.

Historically, when stocks rise after the first five sessions of a year, equities wind up posting gains for the full year nearly 90% of the time, according to the Stock Trader’s Almanac, which has been tracking this and other market barometers for years.

More recently, the correlation has grown even stronger. In a Fidelity article about the January Barometer published last year, Fidelity technical analyst Jeffrey Todd pointed out that “the January barometer has held true 37 of the 39 times since 1950 when January experienced market gains.”

Even so, isn’t this wishful thinking in 2015?

After all, the global economy seems to have hit the skids, as evidenced by the recent drop in oil prices. In fact, Japan is in recession, Europe is in deflation, and China is decelerating faster than folks expected.

Yet the U.S. remains the one economic force in the world that’s holding its own.

And if softness in the global economy keeps the Federal Reserve from raising interest rates until late this year — or even until 2016, as Charles Evans, president of the Federal Reserve Bank of Chicago, thinks it should — that could be just enough good news to keep Wall Street happy in 2015.

MONEY Tech

Apple, Amazon, or Google: Who Will Win the Battle of the Tech Titans?

Illustration of tech robots
Harry Campbell

The Big Three tech giants each want to be the hub of your digital life. Before you invest, learn their strategies, and see which company’s vision is most likely to prevail.

The blueprint for success in technology used to be straightforward: Develop a cutting-edge product people need; build a (near) monopoly; then reap the rewards of controlling that technology—be it the software or chips that make computers run or the switches that make the Internet possible. That was how Microsoft, Intel, and Cisco Systems ruled the ’90s.

Fifteen years after the first great tech stock boom ended, the industry’s new colossal trio of Apple, Google, and Amazon couldn’t be more different from their ancestors.

They’ve created vast arrays of products, from mobile devices to streaming services to payment systems, which they tie together in various ways to support their core revenue stream. Think not of solitary giants, but of giant ecosystems. And those systems, not the latest iPhone or Google Glass or Kindle, are “the defining characteristic of the company,” says Robert Stimpson, co-manager of the White Oak Select Growth Fund.

That means evaluating the strength of those ecosystems is what a tech stock investor has to do. To help, MONEY consulted some of the smartest analysts in the business for guidance and took a hard look at the valuations investors are placing on those systems today.

Apple: Elegant Hardware and Cash to Spare

The heart of the ecosystem: More than 90% of Apple’s $183 billion in revenue in its latest fiscal year came from hardware sales—56% from iPhone sales alone.

Fuel for growth: Hardware is what Apple sells, but it’s not what the company markets. “Apple’s main product is an experience,” says tech analyst Neil Cybart. “They look at all of their products as taking away the complicated part of technology so the users can feel like they have more control over their lives.”

Apple aims to build a world in which you’ll own Beats by Dr. Dre headphones, wear an Apple Watch, buy coffee with the Apple Pay payments system, and make hands-free phone calls via Apple CarPlay. With all those products interlinked and running on Apple’s iOS software, you’ll rely on the ecosystem for daily tasks, making it a hassle for you to buy your next phone or tablet from anyone other than Apple.

Potential threats: Apple has a hit with the iPhone 6 and 6 Plus, selling an estimated 60 million of the phones last year. Indeed, as TIME recently reported, the iPhone 6’s success has cut into Android’s smartphone market share in the U.S. for the first time since September 2013.

But the company isn’t particularly good at ­enticing the owner of one Apple product to purchase another, says Consumer Intelligence Research Partners’ ­Michael Levin.

For instance, only 28% of iPhone owners have an Apple computer, and less than half of them own a tablet, says CIRP. Sales for the iPad have fallen 4% over the past year, acknowledges Apple. But CEO Tim Cook, noting that the company has sold 237 million iPads over four years, told investors in October that he’s “very bullish on where we can take the iPad over time.”

Outlook: BUY

Apple enjoyed a banner year in 2014. Spurred by sales of the latest iterations of the iPhone and anticipation of the Apple Watch’s release in March, the company’s stock rose 40%.

Despite that gain, Apple’s price/earnings ratio, based on projected profits, is just 13.8. That means the stock trades at a 16% discount to the S&P 500 technology index, even though the company’s earnings are growing 33% faster than the average big tech stock’s.

Apple’s low valuation stems from factors such as investors’ doubts that a company its size can grow as fast as smaller tech firms, along with uncertainty that Apple will keep making products that are both popular and profitable.

That said, Apple is still the best company by far at creating exciting technology that people want to buy. Plus, signs point to an ever-increasing dividend from the stock, which now yields 1.8%; a larger payout can be easily covered by Apple’s $155 billion cash reserves.

Amazon.com: Sales Grow, but Earnings Are Scarce

The heart of the ecosystem: Already the world’s biggest online retailer, racking up $85 billion in annual sales, Amazon aims to catch up to the world champion, Wal-Mart, which has just under half a trillion in revenue.

To close that gap, Amazon wants to convert more customers to Amazon Prime, the two-day shipping service now priced at $99 per year. Amazon Prime members make twice as many purchases as nonmembers, and they spend 40% more per transaction, reports ComScore. Prime customers are also loyal: 92% say they’ll renew their subscriptions.

Fuel for growth: To get more people to join Amazon Prime—and buy more goods per year—Amazon has morphed into a streaming-media and mobile-device company.

In 2011 the e-tailer began offering Prime members access to instant streaming movies and television shows; the retailer now produces its own TV programs as well. To ­sweeten Prime, Amazon recently added a streaming-music service and free online photo backups. Plus, when the company launched its Fire smart­phone last year, a one-year Prime membership came bundled free with the device.

The result: There are now an estimated 30 million Prime members, up from around 5 million in 2011.

Potential threats: Amazon has spent heavily on the entertainment it’s using to lure new Prime sign-ups. The company has posted cumulative losses of more than $350 million over the past 10 quarters—vs. the $94 billion in profits Apple churned out. Amazon CEO Jeff Bezos is unapologetic; last year, he reprinted a 1997 letter to shareholders saying that “long-term market leadership” was more important than “short-term profitability.”

One hit to profitability has been the Fire phone. While 10 million iPhone 6’s were purchased the first weekend they went on sale, Amazon reportedly sold only 35,000 of its smart­phones in the first month. Late last year the company took a $170 million charge stemming from the fiasco.

Amazon is learning a hard lesson. It may be a hot retail brand—but not when it comes to cutting-edge technology. “There are people who say, ‘I’m an Apple guy,’ ” says Kevin Landis, a longtime tech investor who runs the Firsthand Technology Opportunities Fund. “I haven’t heard anyone say, ‘I’m an Amazon guy.’ ”

Outlook: SELL

Despite losing a quarter of their value last year, Amazon shares still trade at a whopping P/E of nearly 100, owing to the fact that the company is barely profitable. And even if Amazon cuts costs, problems are likely to persist.

While traditional technology companies enjoy big profit margins, retailers like Amazon don’t, notes Christopher Baggini, a portfolio manager at Turner Investments. Amazon’s operating profit margin has historically been in the low single digits, compared with 20% to 30% for Apple and Google. That means even if Amazon stops spending on losers like the Fire phone, it won’t have Apple and Google’s resources to keep building out its ecosystem.

Google: Helped and Hindered by an Open System

The heart of the ecosystem: Given Google’s driverless cars, ­Internet-connected glasses, and smartphone-linked Nest thermostat, you might think this company was all about the future.

Actually, a lot of what Google is working on is meant to reinforce the past: the company’s roots as a search engine reaping ad dollars based on what people look for online. Advertising still generates about 80% of the company’s $64 billion in annual revenues.

Fuel for growth: The Android operating system, which Google launched in 2007, is essential for protecting its search franchise.

Well before the rise of smart­phones, Google management foresaw that the biggest threat to its business wouldn’t be a rival search engine, says Connor Browne, manager of the Thornburg Value Fund. Rather, he says, the company saw that danger lay in adoption of new hardware: As people shifted from PCs to mobile devices, manufacturers could conceivably eliminate Google’s technology from their products.

Android was the company’s defense against gatekeepers like Apple. While Google doesn’t make much money off the software, An­droid puts the company’s search technology at the fingertips—or voice control—of more than 1 billion people.

For further revenue growth, Google may have to rely on rival Apple’s stronger talents for setting technology trends. Just as Apple’s marketing efforts for the iPhone and iPad created whole new markets for smartphones and tablets, the Apple Watch, scheduled for release in March, could bring wearable devices into the mainstream. Android-based watches came on the market last year, but Apple’s introduction could spark sales industrywide.

The situation is similar for Goo­gle Wallet, the electronic-payment platform that has found less traction in its first three years than Apple Pay did in its first three months. “Google will benefit from Apple making headway in creating a walletless society,” says White Oak’s Stimpson, whose fund owns Google shares.

E-payments are actually more central to Google’s core ad business than to Apple’s success. If you’re watching a video on Google-owned YouTube, for example, companies can run messages tailored to your interests. It would be a natural step—and also seamless—for you to buy an advertised item via Google Wallet.

Potential threats: Start with Android itself. Unlike Apple’s iOS operating system, Android is open source, meaning that Google’s “partners” can tweak it. When Amazon built its Android-based Fire phone last year, it stripped out Gmail and Google Play Store. Fire phones and Kindle tablets link instead to the Amazon Appstore, which competes with Google Play and iTunes.

Similarly, Google can’t dictate which version of Android hardware makers employ. Google Wallet’s convenient “tap and pay” function, for example, requires versions of the operating system that are installed on only 34% of Android phones.

Google also faces threats from other major players. The Chinese e-commerce giant Alibaba, for one, has developed its own smartphone operating system, which could cut into Android’s 80% share of mobile devices in China.

Google executive chairman Eric Schmidt acknowledges the company faces threats known and unknown. “Someone, somewhere in a garage is gunning for us,” he said in an October speech. “I know, because not long ago we were in that garage.”

Outlook: HOLD

As Google’s earnings growth rate has declined, so too has its P/E ratio—from around 25 last year to 18. That means Google stock is 25% cheaper than the average for Internet companies in the S&P 500, even though it’s traditionally been on par.

Paul Meeks, a portfolio manager at Saturna Capital, which owns the stock, notes that there may be more rockiness ahead, as Google keeps reporting lower ad prices. Once that stabilizes, he says, the stock should start to rebound, just as you’d expect any sound ecosystem to recover from a minor disturbance.

In both cases, though, the healing takes time.

See all of the 2015 Investor’s Guide

 

MONEY index funds

The Smart Money is Finally Embracing the Right Way to Invest. You Should Too.

Investors turned their backs on traditional mutual funds in 2014 and began relying more heavily on indexing.

Since launching the Vanguard 500 fund in 1975, Vanguard founder Jack Bogle has been preaching the gospel of indexing — a plain-vanilla, low-cost strategy that calls for buying and holding all the stocks in a market and “settling” for average returns. He’s so fervent that his nickname in the industry is St. Jack.

Forty years laters, investors have finally found religion.

In 2014, the Vanguard Group attracted a record $216 billion of new money, largely on the strength of its index offerings and exchange-traded funds. These are funds that can be traded like individual stocks and that almost always track a market index.

Vanguard wasn’t alone. Blackrock, which runs the well-known iShares brand ETFs, attracted more than $100 billion of new money in 2014, a year in which investors both small and large embraced indexing, also known as “passive” investing.

By comparison, actively managed mutual funds — those that are run by traditional stock and bond pickers — saw net redemptions of nearly $13 billion last year, according to the fund tracker Morningstar.

There’s are several simple reasons for this:

1) Fund inflows generally follow recent performance.
And in 2014, the S&P 500 index of stocks outperformed roughly 80% of actively managed funds, noted Michael Rawson, an analyst with Morningstar.

He added: “When the market rallies strong, a lot of active managers tend to lag, maybe because they’re being more conservative, holding more quality stocks, or maybe holding a little bit of a cash — it is common for an active manager to hold some cash. So it’s difficult to keep up with the rising market.”

2) 2014 was a year when many heavy hitters espoused their preference for indexing.
In August, MONEY’s Ian Salisbury reported how the influential pension fund known as Calpers — the California Public Employees’ Retirement System — was openly considering reducing its use of actively managed strategies for its clients.

This came on the heels of a provocative column written by a Morningstar insider questioning whether actively managed strategies had a future. “To cut to the chase,” wrote Morningstar’s John Rekenthaler, “apparently not much.”

And as MONEY’s Pat Regnier pointed out in a fascinating piece on Warren Buffett’s investing approach, the Oracle of Omaha noted in his most recent shareholder letter that his will “leaves instructions for his trustees to invest in an S&P 500 index fund.”

3) Plus, new research from Standard & Poor’s shows that even if active managers can beat the indexes, they can’t do that consistently over time.

The report, which was published in December, noted that “When it comes to the active versus passive debate, the true measurement of successful active management lies in the ability of a manager or a strategy to deliver above-average returns consistently over multiple periods. Demonstrating the ability to outperform repeatedly is the only proven way to differentiate a manager’s luck from skill.”

Yet according to Aye Soe, S&P’s senior director of global research and design, “relatively few funds can consistently stay at the top.”

Indeed, only 9.84% of U.S. stock funds managed to stay in the top quartile of performance over three consecutive years, according to S&P. This is presumably because over time, the higher fees and trading costs that actively managed funds trigger become too difficult for even the most seasoned managers to overcome.

Even worse, just 1.27% of domestic equity portfolios were able to stay in the top 25% of their peers for five straight years. For those funds that specialize in blue chip stocks, the numbers were even worse. Of the 257 large-cap funds that finished in the top quartile of their peers starting in September 2010, less than half of 1% remained in the top quartile for each of the subsequent 12-month periods through September 2014.

As Soe puts it, this “paints a negative picture regarding the lack of long-term persistence in mutual fund returns.”

MONEY stocks

Why Main Street’s Gain Is Wall Street’s Pain

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Trader Joseph Mastrolia works on the floor of the New York Stock Exchange while wearing 2015 novelty glasses on New Year's Eve, the last trading day of the year, in New York December 31, 2014. Carlo Allegri—Reuters via Corbis

Monday's 331-point drop in the Dow shows that the tables have turned on Wall Street.

Up until now, the bull market seemed to defy the everyday experience of many Americans: As Main Street households struggled through a recovery that repeatedly fell short of expectations, investors on Wall Street rejoiced.

That’s because the economy was growing fast enough to justify higher share prices, but not so fast that inflation was viewed as a real threat.

This year, though, the script seems to be flipped.

As Main Street Americans finally begin to see the economy improving, it’s the stock market that’s falling short, as evidenced by Monday’s 331-point drop in the Dow.

Monday’s dive was driven by two major economic trends that on the surface should be a boon for U.S. consumers. First, oil prices continued their sudden and surprising slide, driving prices at the pump down with them.

Brent Crude Oil Spot Price Chart

Brent Crude Oil Spot Price data by YCharts

At the same time, the U.S. dollar is now at a nine-year high against the struggling euro. That bolsters the purchasing power of Americans traveling abroad and U.S. consumers purchasing imported goods.

^DXY Chart

^DXY data by YCharts

Thanks to both trends, auto sales last year reached their highest level since before the global financial crisis.

Yet none of this is moving the dial on stock prices so far in 2015.

Some analysts think this could be a recurring trend throughout this year. “Expect a good year on Main Street but a more challenging environment for Wall Street,” says James Paulsen, chief investment strategist for Wells Capital Management.

Why?

Before, lukewarm news on the economic front bolstered the hope that the Federal Reserve would keep interest rates near zero for the foreseeable future. Now, some investors worry that the forces causing oil prices to fall and the dollar to rise — the weak global economy abroad — may be too much for the Fed to tackle even if rates stay low throughout this year.

Moreover, falling oil prices and the strengthening dollar may be giving the market false hope about low inflation.

“Some have argued that lower oil prices give the Fed more room to maneuver. This is a mistake,” says David Kelley, chief global strategist for J.P. Morgan Funds.

While it is true that lower energy prices are reducing inflation in the near term, “falling oil prices are also a big boost for consumers,” Kelly said. “Even if gasoline prices were gradually to move up to $2.75 a gallon by the end of this year from $2.39 at the end of last year, consumers would spend roughly $90 billion less on gasoline in 2015 than they did in the 12 months ended in June 2014.”

Not only is this a financial boost, “it is also a psychological positive with sharp increases seen in consumer confidence readings in the last few weeks,” Kelly said. “This should power an increase in consumer demand which should, in turn, boost prices in other areas.”

MONEY Economy

Economy Delivers a Last-Minute Gift to Wall Street

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Getty Images/Purestock

The U.S. economy isn't exactly partying like 1999, but it came pretty close in the third quarter, growing faster than it has since 2003.

It’s time to stop describing this economic recovery as being “tepid.”

A new report from the Commerce Department Tuesday morning revealed that the U.S. economy had grown at an annual rate of 5% in the third quarter. Not only does that represents a major jump from earlier estimates of 3.9% growth, it marks the economy’s best performance in 11 years. And it’s the second straight quarter in which U.S. gross domestic product grew at or near the historically high mark of 5%.

Wall Street reacted as you’d expect, pushing the Dow Jones industrial average up another 60 points in early morning trading Tuesday to above the 18,000 mark. In just the past week, the so-called Santa Claus rally has now lifted the benchmark Dow up nearly 1000 points.

Most of that rally, however, centered on the bad news surrounding the global economy, as the slowdown overseas is putting a lid on inflation and allowing the Federal Reserve to keep interest rates near zero for some time.

Today’s bump, though, was all about the surprising health of the U.S. economy in general and American consumers in particular.

Earlier reports showed that consumer spending, which represents more than two thirds of total economic activity in the country, had grown a decent 2.2%. But today’s new report updated that figure to 3.2%. “The boost to personal consumption was much stronger than we had expected,” noted Michael Gapen, chief U.S. economist for Barclays Research.

This would imply that the improved job market and rising net worth due to improvements in the stock and housing markets are finally being felt by American households—just in time for the holidays.

MONEY Economy

Dow Races Past 18,000

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Jeffrey Coolidge—Getty Images

But is this "Santa Claus" rally in the stock market being driven by an economy that's naughty or nice?

The Dow Jones industrial average climbed above the 18,000 level for the first time ever, shortly after the government released a report showing the U.S. economy grew at an annual rate of 5% in the third quarter—much faster than was initially thought.

The report also pointed out that consumer spending increased faster than expected, a sign that the improving labor, stock, and housing markets are finally being felt by American households.

Given this fact, conventional wisdom says the market is enjoying a normal Santa Claus rally. But conventional wisdom is wrong. Here’s why:

At the end of most years, stocks tend to surge for reasons of good tidings and good cheer. This year, however, the bulk of the near 1,000-point rise in the Dow that began a week ago has really been driven by bad news around the world.

As economies in Europe, Asia, and Latin America have all slowed more than expected, expectations for global growth have sunk, driving down oil and commodity prices. In fact, crude oil prices have tumbled by nearly half, to around $61 a barrel since the summer.

Brent Crude Oil Spot Price Chart

Brent Crude Oil Spot Price data by YCharts

For American consumers, this is an early present from the North Pole. The average price of regular-grade gas in the U.S. has fallen to $2.47 a gallon, the lowest point since 2009, which leaves more money to stuff into Christmas stockings at this time of the year.

Yet for large parts of the rest of the world, falling oil prices and the slowing economy spell trouble.

Falling energy prices, for instance, are wreaking havoc on the budgets of emerging economies that are dependent on oil revenues to maintain their finances. Russia, Algeria, Iraq, Iran, Nigeria, and Libya all require oil prices above $100 a barrel to keep their debt/gross domestic product ratio from rising, according to a recent report from Goldman Sachs.

Even Middle Eastern oil producers such as Kuwait, the United Arab Emirates, Qatar, and the Saudis need oil above $63 a barrel to maintain their financial health, yet oil is barely over $60 a barrel now.

As global economies start to sputter, investor faith has faltered, as seen by the flight of cash away from global currencies into the U.S. dollar. In recent months, the value of the dollar has jumped nearly 13%, which strengthens the buying power of Americans but hurts the finances of most of the rest of the world.

^DXY Chart

^DXY data by YCharts

To keep their currencies from losing even more value, central banks around the world are now in the unenviable position of having to raise interest rates even as their economies crave rate cuts to boost growth.

The U.S. Federal Reserve is the one big exception.

While Fed chair Janet Yellen has denied that global economic worries are influencing the Fed’s decisions on setting U.S. interest rate policy, the consensus on Wall Street is that they clearly are a factor.

Last week, just before the Santa Claus rally ignited, the Fed’s Federal Open Market Committee (FOMC) announced — as expected — that it would keep short-term rates near zero. The committee, however, threw Wall Street a curve ball when explaining its decision. For months, the Fed said that it expected that rates could stay near zero for “a considerable time.” Investors were bracing for that language to be removed from its December press release since the U.S. economy was starting to get into gear.

As it turned out, “the phrase ‘considerable time’ was not dropped from the latest FOMC statement as was widely expected. Instead, it was reinforced with a new phrase stressing that the Fed can afford to be ‘patient’ before starting to raise interest rates,” said Ed Yardeni, president of Yardeni Research.

In so doing, “the Fed didn’t remove the punch bowl; they spiked the punch,” says Sam Stovall, U.S. equity strategist for S&P Capital IQ. “Akin to lighting the tree at Rockefeller Center, this response to the Fed’s actions may have signaled the start of the Santa Claus rally.”

Why did the Fed cling to this “patient” sentiment?

Because the global slowdown allowed it to.

The U.S. economy is clearly gaining momentum, as Tuesday morning’s GDP report clearly showed. But cheap oil caused in part by a global slowdown means that consumer prices in the U.S. should be stable. That means even as GDP is rising at a brisk pace, the Fed can keep stimulating the economy with low interest rates without fear of inflation.

In other words, what’s bad for the world is good for the U.S.

Merry Christmas.

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