Let the Good Times Roll

- 2013 4th Quarter


As 2014 begins we all wonder:  can we possibly repeat 2013? The Dow Jones Industrial Average returned 29.7% last year and the S&P 500 was up 32.3%. Those are incredible returns no matter the year, but can the stock market do it again in 2014? There are reasons to be concerned and reasons to be bullish going into this year.  Although 2014 will see the end of Quantitative Easing in the U.S, the global economic and policy environment should still allow for further investment growth.  For the first time since the Great Recession, U.S., China, Japan, and Europe should all show growth at the same time. Experts believe that this economic expansion will gain momentum throughout the year and be sustainable.  But, before we talk more about the year to come, let’s see how the 2013 left us.

The 4th Quarter:
The U.S. stock markets continued to set records with the S&P 500 Index capping its best yearly gain since 1997 and the 10 year U.S. Treasury Note reaching a two year high of 3.03%. U.S. stocks rallied as the economy finally showed signs of gradual improvement while the rising tide of Federal Reserve (Fed) bond buying lifted all ships.

With that said, 2013 was filled with ups and downs: reduced Federal Reserve stimulus, a new Fed chairman, federal government shutdown, and U.S. stocks gains.  Predictions point to continued earnings and profit growth while inflation and bond yields will remain low. Stocks rose for a fourth-straight month in December as investors seem to disregard the Fed bond purchase tapering. Further, with the exception of REITs and Commodities, all Risk-Based Assets generated positive returns led by U.S. stocks: Large Cap stocks (10.48%) took the lead with U.S. Small Caps(8.71%) and Mid Caps (8.31%) close behind. International stocks (5.78%) also had a strong showing led by Japan’s Nikkei 225 Index with a 12.76% return. Emerging Markets stocks were slightly positive (1.87%) led by China (3.95%)

On the flip side, the bond market dipped in 2013, as worries that the U.S. Federal Reserve would taper its “quantitative easing” program. News of the tapering, from $85 billion per month to $75 billion per month beginning this month, caused investment-grade bonds to suffer their worst year since 1994.  This also represented the second-worst year for investment-grade debt since 1980, the first loss since 1999, and only the third time in 34 years the asset class finished the year in the red. With that said, investors still saw some success with high yield bonds, senior loans, and short-term bonds.

The Federal Reserve assured investors that interest rates will stay low and it would wait until the unemployment rate declines below 6.5% before any interest increases. The unemployment rate in December fell to 6.7 percent, the lowest since October 2008, as more people dropped out of the labor force. Economists were looking for the jobless rate to hold steady at 7 percent. 

The World Economy in 2014:
With 2013 going out with a bang, it looks as if the global economic growth will continue to gain momentum into 2014 due to:

  • the systematic removal of quantitative easing;
  • a steady leadership change in the Federal Reserve;
  • an upgraded U.S. fiscal situation;
  • economic steadiness in Europe;
  • a vigorous monetary policy in Japan;
  • and supply side reforms with respect to spurring market competition and reducing the direct role of the state in economic affairs in China.

Locally, the gross domestic product, one the primary indicators used to gauge the health of a country's economy, looks towards growth with the labor market improving due to less stringent credit conditions allowing the housing market to recover as well as ramp up corporate spending. The housing market bottomed out in 2012 but made a positive contribution to economic growth in 2013.  

Experts predict that the U.S. economy will grow at a 2.5%-3.5% rate and that the Fed Reserve monetary policy will remain highly consumer-friendly for 2014 and into 2015. This policy should last as long as the economy is still bouncing back, the unemployment remains high and corporate and worker pricing power is limited. The two year budget agreement reached last month lays the groundwork for federal tax and spending policies in 2014 that are less restrictive to economic growth than it was in 2013. Inflation should remain low and stable while a sustained period of deflation should be avoided.

As for the international markets, European stocks are no longer cheap, but valuations are not stretched. Growing momentum in the Japanese economy combined with stimulating fiscal policies should be bullish for Japanese stocks. Australian stocks may struggle in the first half of the year based upon their commodity dependence. As the year progresses and global growth accelerates and proves sustainable, the environment for Australian stocks should become bullish.

In emerging markets (EM) stocks, we are cautious due to the fragility of global economic growth. Many of the EM countries have independent economies each in different parts of the economic cycle.  Countries in East Asia, led by China, South Korea, and Taiwan, have stronger economic fundamentals than India and Latin American countries and they are actively engaging in economic restructuring which should be very bullish for future growth. Economies in Latin America have been hurt by falling commodity prices while India has low growth with high inflation.
    
The Effects of the Tapering of Quantitative Easing of 2014:
It’s the end of Quantitative Easing as the Fed will continue to withdraw QE gradually - using incoming data as a guide regarding future tapering decisions - and keep the fed funds rate low indefinitely. This is largely what the markets were expecting, and it represents a positive development in the long-awaited end of tapering removing the element of uncertainty that has been hanging over the markets for months.

What will the effect of the Quantitative Easing be? It’s anyone’s guess but it would appear that volatility of global, risk-based assets and bonds could increase in 2014.  How the tapering is handled will have an effect as will the process by which U.S. politicians raise the Federal debt limit in the spring. Investors shouldn’t really worry about the actual act of tapering so much as how this process will unfold.  At the moment the consensus is that there is a 100% chance that all quantitative easing/bond buying will be phased out by the end of 2014. However, several Fed officials have indicated that they are likely to keep the Fed Funds rate at near 0% levels for a long time after the bond buying has been phased-out.

Conclusion. 
After generating an 18% annualized return over the last five years, the S&P 500 seems fairly valued. With that being said, the U.S. stock market should once again be the performance leader as the profits of U.S. multi-national corporations will benefit the most from a cohesive global recovery. The transition to self-sustaining growth should provide an acceleration in revenue and earnings growth. The outlook for US equities may be positive, but they are not cheap and current valuations may have borrowed from the future.  With respect to sectors - Technology, Industrials, Finance, and Consumer Discretionary should perform well as the economic recovery accelerates.  On the flip side, the 30+ year bull market in bonds is over and the overall fixed income outlook is bearish.

The Fed has done an excellent job engineering the nation's recovery with the US recovery far more advanced than the rest of the developed world. Investors are, however, being forced to take on more risk to earn an adequate return.  In spite of all the doom, gloom, caution and diversification talk, mainstream US equities have been the strongest since the 2008 financial crisis. Long term US bonds have also been easy pickings for more than three decades, but as noted, the fixed income dynamics have changed.

So, as a participant in a retirement plan, how should you approach 2014?  In the words of Peter Lynch, "Know what you own, and know why you own it." Now is the time to revisit your investments and make sure you are still properly invested. As the Market recovers, now is a good time to increase your contributions which will in turn increase your retirement nest egg.  As always, we are here for you if you’d like to do a “check-up” on your account to ensure it is satisfying your goals and objectives and/or that you are contributing enough to achieve your desired retirement.  Please do not hesitate to contact us.  

Happy New Year,

David A. Krasnow


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