“Reality is merely an illusion, albeit a persistent one.” – Albert Einstein
“One person’s craziness is another person’s reality.” – Tim Burton
It’s quiet out there … really quiet. At least as far as the markets are concerned. With the stock market indexes up strong, and no market “correction” of more than a few percent, 2013 turned out to be one of the strongest years ever for the stock market indexes. Sure we saw a rise in interest rates and movement in commodity prices. But having a little perspective, anyone invested in equities, either in whole or as part of an allocation, should enter 2014 feeling good about their investment portfolio.
Markets – all markets – can become mispriced. For a period of time they can be incredibly overvalued, or undervalued. Think bond prices in 2012 or the NASDAQ in 1999 (overvalued); Think gold and silver in 2003 or the stock market at the market bottom in March, 2009 (undervalued). For the experienced investor the signs can be clear when extreme valuations are evident. After such a good year for equity investors we need to ask a few questions. Can 2014 be a repeat of 2013? Or is the stock market overvalued? And what about bonds and bond yields?
A Look Back – 2013 Year Review
In a rising interest rate environment one would expect the stock market to struggle at best, and end the year in the red at worst. What we got, however, was nothing short of spectacular. For 2013 the S&P 500 was up 29.60%, the NASDAQ up 38.32%, and the Dow Industrials up 26.50%.
On the other hand, interest rates started the year at historically low levels and, while quite a bit higher, are still at historically low levels. And for as bad of a year as bonds had, the Barclays Aggregate Index was “only” down 2.03% for the year. As for commodities, like any other year they were all over the place. Gold was down 28%, but natural gas prices were up 35%; Corn lost almost 40% of its value while cocoa increased by more than 25%.
For all the talk about events away from the markets – Federal Government shutdowns, implementation of the Affordable Care Act, below trend economic growth, a possible accord with Iran, and unrest in the Middle East – we look back on 2013 with a yawn. Not the kind with your mouth wide open that envelopes your entire face, more like the small one you can stop mid-yawn. If you sat and watched the markets without reading a newspaper article or listening to a market debate on CNBC, you would have never thought there was anything of substance going on in the world.
The Year Ahead – Investing in 2014
Economically, we are still living in interesting times. In the United States we have seen good (not great) private sector job growth again in 2013. More importantly, as the year progressed, job creation has increased, with the monthly jobs numbers growing as the year moved on. We need to keep in mind that, even discounting for the 10,000 or so Americans who are turning 65 each day and, thus, leaving the workforce due to retirement, the unemployment rate remains inflated on an historical basis. As a result, economic growth has continued to be slower than you want to see four years into a recovery.
Globally the story gets more interesting. Over in Europe, 2013 brought what could have been the bottom of this economic cycle for that region, but not without risks. The ECB has shored things up via aggressive policy decisions, yet deflation is not yet out of the realm of possibilities. China is in the midst of a dramatic restructure of its economy, starting the well-anticipated move from an export dominated economy to a more developed economy. And let’s not forget that the Chinese Government has been more aggressive in asserting itself as a regional power. With all that happening, Japan is in the middle of what appears to be a serious attempt to devalue the Yen.
Away from economics and politics, there are real issues that to put into perspective. In 2013, for example, The Fed talked about decreasing the amount of bonds they have been purchasing in the open market from $85 Billion each month to something less than $85 Billion. The markets were not happy. Stock prices fell, currency relationships changed quickly; money began to flow out of the emerging economies, while global bond values moved powerfully against the holder of those bonds. Now that outgoing Fed Chairman Bernanke has officially announced the start of tapering in January, 2014, we have to see how markets react this time around.
Put all of that together and 2014 is looking like it can be a rather interesting year.
So let’s dig in …
What a year 2013 turned out to be for equity investors. With the exception of the gold sector, it was a good year. Not only were the market indexes up strongly, but the fundamentals of corporate America remained solid. Profits and margins, in general, continued to impress during the 5th year of this bull market. With an economy that continues to steadily grow, there is no reason to expect there to be a change in direction.
And while corporate America is in very good shape, the markets are certainly not cheap. Some of the gains in 2013 were the result of multiple expansion (people willing to pay more of a premium for companies than they previously had). More expensive, however, does not mean we believe the stock markets are in a “bubble,” which only occurs when stocks are priced at irrationally high valuations due to uninhibited investor enthusiasm. Forward P/Es are around 16, not 26. And last we checked, there are no “hot stock tips” from the mailman/garbage man/dry cleaner /random guy at the gym. No bubble does not equate to no risk however.
Moving from fundamental analysis to market cycles, 2014 is a very interesting beast. Thinking shorter-term, we are in the second year in the 4-year Presidential Cycle, a notoriously bad year for the stock market indices, with years 3 and 4 generally producing the best results. After the outstanding performance in 2013 we expect there to be even more pressure than normal on the markets.
From a big picture perspective, it is obvious now that the last Secular Bull Market ended in March, 2000. As Secular Bear Markets on average last 17 years, the breakout above the March 2000 and October 2007 highs does not necessarily mean we have another decade plus of positive markets. In fact, coming out of the last Secular Bear Market in the early 1980s, we saw the market average break above old highs in 1980 was not sustainable. The stock market corrected one last time before finally breaking out for good in August 1982.
So what does this mean for equity indices in 2014? We see 2014 being much harder AND much more volatile for equity investors. This doesn’t mean we will see a negative return for 2014, but we do not expect 2014 to be a repeat of 2013.
As a base-case scenario we expect the market to be choppy and a bit frustrating. A correction of 10%+ should finally materialize, very possibly from a higher price level and most likely when it is least expected. After more than four years of steady, upward gains, we expect the individual investor to become quickly skeptical of the stock market. Ultimately this is what will lead market indices to modest, new high levels. Our opinion is that a gain of 5-7% in 2014 seems reasonable. We come to this conclusion for three reasons:
- The last true correction of the U.S. stock markets happened more than two years ago. This is a long time for markets to be this calm.
- While corporate earnings have been very good – outstanding at times – these earnings have not been of the highest quality. Many of the largest companies have repurchased large quantities of their shares on the open market the past few years. As a result, there are less shares and thus greater per-share profits for the same earnings. Some would call this financial engineering. Combine this with the boost to earnings received from lowered interest rates (and the lower cost of borrowing) and you have a chunk of earnings growth that is not a result of growing sales.
- The tapering of/end of Quantitative Easing by The Fed. With the end of both QE1 and QE2 we saw the stock market drop. Why would the end of QE3 be any different? Can The Fed increase their balance sheet by $1 Trillion and have zero repercussions when it stops buying?
As an alternative to our base-case, we can see a year in which the stock market indexes simply move sideways all year without a correction. There are times where markets “correct” without necessarily having a selloff in prices. In 1994 this happened, even as corporate earnings increased, the market bobbed around but essentially remained flat for the year, digesting the gains of the previous few years without a serious breakdown in the index (see Figure #1).
Stocks offer long term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Investments that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than investments that are more diversified. Technology and internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.
Bonds and Income Investing
In our 2013 Market Outlook, we noted the bond investor was facing a sizable interest risk inherent in the markets. With interest rates at low levels, our best case scenario was modest gains for the bond investor. At the time we noted three factors that could have a negative effect on bonds:
- Issues related to the U.S. Government Debt Ceiling – Congress and the President have to come to a resolution to the debt ceiling before the first quarter ends. If a stalemate occurs, forcing the U.S. Government to even partially default on payments, chaos could occur. In such a situation, it seems reasonable to assume investors will sell their U.S. Treasury Bonds, causing higher interest rates (and falling bond values).
- A steady increase in rates could cause small investors to sell their bond funds, causing interest rates to continue to rise in the face of Fed purchases. In recent years there have been heavy inflows into bond funds, contributing to the depressed yields available in the market. A reversal of this trend would likely have the opposite effect.
- The Fed decides to slow or stop its asset purchase program.
Of the three issued mentioned, the first two were real factors, with the start of “tapering” set to begin in January, 2014. While there was never a default on U.S. Treasuries, we did move perilously close to one while in the middle of a Government shutdown. Fortunately, the markets didn’t believe that our representatives in Washington would seriously jump off that cliff.
For 2014 we expect any increase in the 10-year Treasury yield to be restrained by The Fed’s stated policy of holding short-term borrowing rates at close to zero. This gives the income investor a chance in interest rate sensitive bonds. We do not, however, see rates falling precipitously here, given the technical break above the long-term downtrend line (See Figure 2).
We continue to believe the best risk/reward scenario is to have a bond portfolio which is more credit sensitive and less interest rate sensitive as global diversification remains important. While it is certainly possible we have falling interest rates, we believe it is not the probable outcome. As long-term investors we prefer to concentrate on the bigger trends, not the short-term noise.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
While stocks generally have a greater potential return than government bonds and treasury bills, they involve a higher degree of risk. Government bonds and treasury bills, unlike stocks, are guaranteed as to payment of principal and interest by the U.S. Government if held to maturity.
Generally, CDs may not be withdrawn prior to maturity. CDs are FDIC insured up to $250,000 per depositor per insured depository institution for each account ownership category. CDs may be issued by out of state institutions.
Quiet and boring is good when it comes to investments. For all the headlines coming out of Washington, Shanghai, Tokyo, London, etc., there was not much that could affect the direction of the markets. Our reality in 2013 was one of much higher equity prices, higher bond yields at the long-end of the yield curve, and a mix in the commodities markets.
For 2014 our expectations are simple. For equities we expect to see a real correction of 10% or more come to the market indices at some point this year, but markets higher by the end of the year. As good as it has been for the equity investor, the stars are lining up for some negative action. Markets aren’t cheap. Fundamentals have been suspect, with reason to question if forward expectations have become overdone. Cyclically we are in the second year of the Presidential cycle, the historically weakest of the four years. Then there is the ending of QE by the Fed. We find it hard to believe that this will end better than the end of QE1 or QE2. To expect the market to just carry on without the stimulus it has been milking for the past few years just doesn’t feel right to us. In the end we will be ok, but we do see a market pullback as the base-case scenario.
For the bond investor 2014 looks to be another challenging year. Fortunately, there should be a limit to how high rates of longer-dated bonds can go as The Fed is committed to holding short-term rates low. While placing a target on rates is an act of futility, we would be hard pressed to see a way for the 10-year Treasury rate to get above 3.75% in a sustainable way. Still, the bond markets remain a challenge. We believe it is prudent in the current environment to take more credit risk than interest rate risk with a bond allocation.
On behalf of Magellan Financial we would like to thank you for taking the time out of your busy day to consider our report. If you found this helpful, please forward it onto others. If you have any questions on the materials presented or would like to be added to our email list, we can be contacted at 610-437-5650 or via email.
Past performance does not guarantee future results.
Exchange Traded Funds seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched. Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
Technical analysis is only one form of analysis. Investors should also consider the merits of Fundamental and Quantitative analysis when making investment decisions.
Asset allocation and diversification do not ensure a profit or protect against a loss in a down market.
Margin borrowing may not be suitable for all investors. When you use margin, you are subject to a high degree of risk. Market conditions can magnify any potential for loss. The value of the securities you hold in your account, which will fluctuate, must be maintained above a minimum value in order for the loan to remain in good standing. If it is not, you will be required to deposit additional securities and/or cash in the account or securities in the account may be sold.
Indices are unmanaged and you cannot invest directly in an index. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value. The Dow Jones Industrial Average is an unweighted index of 30 “blue-chip” industrial U.S. stocks. The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. The Barclays Capital U.S. Aggregate Bond Index is composed of the Barclays Capital U.S. Government/Credit Index and the Barclays Capital U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Robert I Cahill, Managing Partner
Jeffrey T. Bogert, Partner Jeff.Bogert@wfafinet.com
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Ann L. Drescher, Partner Ann.Drescher@wfafinet.com
Jay Knight, Associate Financial Advisor Jay.Knight@wfafinet.com
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