4th Quarter 2013: The stock market was up strongly again in the fourth quarter bringing an end to a strong year.
4th Quarter results:
It would be a bit of an understatement to say that 2013 was a good year for the stock market. Seemingly nothing, from the rapid rise in interest rates last spring as the Fed prepared to exit its quantitative easing programs to the government shutdown in the fall, could stop the bull market in 2013. The S&P 500 and the Dow Jones Industrial Average hit all-time highs in the past year.
The biggest story in the fourth quarter, and for all of 2013 for that matter, was the Fed’s quantitative easing program. The market was fixated for months on the timing of the central bank’s exit from its signature program. Starting in the first half of the year, chairman Ben Bernanke began discussing the possibility of tapering the purchases of securities in the face of improving economic data. The discussion in May led to a sharp and sudden increase in Treasury rates as the 10-year Treasury yield moved from 1.7% at the start of May to 2.2 % in less than four weeks. The move in rates set off a communication campaign by the Fed to convince the market that they would not begin the taper until the economy was strong enough to support it and that short-term rates were going to remain extremely low for the foreseeable future.
The PR campaign seemed to have worked at least for the stock market. By the time Fed officials announced in December that they were going to reduce the size of their bond purchases by $10 billion a month to $75 billion monthly, the market reaction was quite muted as investors had already priced in the taper. The markets continued to rise through the end of the year.
Interest rates continued to rise in the fourth quarter, however, with the 10-year Treasury rate touching 3% just before the end of the year. This story is far from over. The Fed still has a long way to go to exit all of its extraordinary measures. If 2013 shows us anything, it was that it’s incredibly difficult to predict how the market will react to the Fed’s moves in the years to come. Just as there was no road map putting these interventions into place, there is no clear path of how to exit them.
During the past year, small and mid-cap stocks outperformed large, and growth was mostly better than value. As the economy stabilized throughout the year, investors became less worried and sought more risky investments which tend to be available in smaller companies as well as in the growth sector.
Despite the ongoing bull market, stocks continue to look approximately fairly valued. While price/earnings multiples are above 100-year averages, they are generally consistent with levels of the past 25 years. Investors may be tempted to take profits, hoping to buy back in at better prices down the road. However, timing the market in this way is extremely difficult. Companies will continue to collect cash flows, grow their earnings, and raise their dividends over time. Intrinsic value, which drives the price of stocks, is a moving target.
American business will do fine over time. Stocks will do well just as certainly since their fate is tied to business performance. Setbacks may occur, but investors and managers are in a game that is heavily stacked in their favor. The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering increase of 17,320%. This was despite four costly wars, a Great Depression and many recessions.
We expect GDP to grow at a 2.0-2.5% rate, which is low historically for economic recoveries. Anything larger than this will give added impetus to stock prices. We expect the stock market to continue to go up although not as much as it did in the past year. A return of 7-8% seems to be the consensus for 2014. However, the expectations for 2013 were in the 10% range which was dramatically lower than the high 20% returns realized this past year.
We expect that it is likely that interest rates will continue to rise in 2014. This means that it will be hard to get decent returns from bonds. This fact makes it likely that more people will be moving into equities as the year progresses.
Investment strategy 4th Quarter 2013:
Our portfolios have done extremely well this year. At the beginning of the year, we anticipated that earnings would increase about 10% for corporations. This would result in a market return of about 12%, 10% earnings and 2% in dividends. Our holdings in equity funds did better than that. Bonds, in portfolios for safety, had poor returns early in the year. Because of this we took a risk and moved them into equities. The result was extremely positive as can be seen by strong gains for the year.
One of our major concerns is to insure that we have some diversification and that all funds are not in one area such as large growth or large value. Most of our clients' portfolios had the biggest holding in the large-cap area and in particular the large-cap growth area. Growth funds did well in 2013 although small and mid-cap funds did better than large-cap funds. Growth did do better than value funds in 2013 and are expected to do better in 2014 as well. Most portfolios have a fair amount in health, an area that did extremely well this year. Nevertheless we continue to have representation in other areas which gives good diversification.
We will watch the market carefully as always to see if it is appropriate to move some dollars out of equities into cash or even bonds if the market starts to drop substantially.
Bruce A. Kraig, January 4, 2014
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