After a big 2013 for stocks, this year got off to a rough start as stocks sagged in January. Share prices bounced back, however, and the average diversified U.S. stock mutual fund ended the first quarter of 2014 with a return of 1.3%.
1st Quarter Results:
How quickly they forget. Just last year, U.S. stocks were stars. This year they get no respect. After soaring last year, the S&P 500 rose just 1.8% in the first quarter. The Dow Jones Industrial average was worse, falling -0.2%. The problem: sluggish economic performance and projected first quarter earnings were not strong enough to push stocks higher after huge 2013 gains. Investors realized the economy was still not back to normal.
Last year’s gains were recognition of low inflation, good corporate earnings, and supportive monetary policy. Now, the stock market more fully reflected that good news. All of that was behind us and more gains required more upbeat news.
In the past three months, value funds, those investing in higher dividend paying stocks, outpaced growth funds. This was a reverse from 2013 when investors invested in riskier funds. In recent months, fixed-income investors watched anxiously as the Federal Reserve scaled back its bond-buying programs, a first step toward nudging interest rates higher. This resulted in losses for bonds in 2013. But the yield on the benchmark 10-year Treasury note actually trended lower during the first quarter and bond prices rose.
The stock market was showing several signs of strain. Rapidly growing sectors such as bio-technology were falling back as investors shifted money to cheaper stocks that hadn’t risen as much and to safer, dividend paying stocks. The most immediate concern was the profits reports. An estimate was that profits at U.S. companies rose just 1.2% in the first quarter from a year earlier. This estimate was probably too low, but if the increases aren’t at least 4.9% they will be the weakest since mid-2012, two years ago.
As the bull market turns five years old, stock investors have a lot to celebrate.
As mentioned above, however, this bull market is showing its age. It is now the fourth longest in history. The question now is whether the still-soft economy can push stocks higher as the Federal Reserve slowly ends the multi trillion dollar stimulus program that has supported stocks for so long with cheap money.
The widespread expectation is the bull market isn’t over but will rely increasingly on improvements in the economy rather that Fed support. Many money managers believe the character of the market is changing. It doesn’t look like the stock market is going to get year after year of double-digit growth as it has in recent years, but the bull market can continue as long as we get continued economic growth pushing stocks higher.
Further gains are far from guaranteed. Stocks are no longer cheap by historical standards. For them to keep rising, U.S. corporations must push profits higher at a time when profit growth has slowed. An economic glitch or a sudden upswing in interest rates could put an end to stock gains.
The S&P 500 now trades at 16 times its component companies’ earnings for the past year. That is double its level of five years ago and almost identical to the level at which stocks peaked and began their decline in October of 2007. A broader measure of stock prices measures the S&P against a 10-year average of earnings. It puts the S&P at 25 times earnings, far above the historical average of 16.5, but not quite back to the 27.5 hit in 2007. These measures show that stocks are riskier than before but they do not, of course, tell us where we are going in the future.
Investment Strategy 1st Quarter 2014:
If stocks are risker than before, what is the strategy going forward? Is a bear market likely? And if so, should investors move to cash to avoid a drop? Few investors find solace from knowing that, if they wait long enough, stocks will eventually recover from a bear market. After all, as Keyes said, in the long run, we are all dead. Yet history shows that typical bear-market recovery times are hardly “the long run.” Since 1926, it has taken an average of 3.3 years for stocks to surpass their high set before the typical bear market began. Unless you think the next bear market and subsequent recover will be worse than average, sticking with stocks is the best response to the certainty that, sooner or later, the current bull market will come to an end.
That said, as we actively monitor the market daily, when the market was down 4-5% at the end of January, and it was possible the market might drop substantially more, we moved some dollars out of the small-cap sector. This area was up the most in 2013 and had the highest price-multiple stocks which meant that it had holdings that were perhaps slightly overpriced. Although the market recovered in February and March, it has recently fallen back again. Moving dollars out of this small-cap area was a conservative move. These small-cap funds are the most volatile and will fall more than larger-cap funds if the market should take a bigger drop.
We remain positive on the market, but it is wise to be safer given the huge gains we have had over the past several years. Depending on market trends we will move these dollars back into equity funds or add to money markets and bond funds.
Bruce A. Kraig, MBA, CFP
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