2014 1st Quarter Outlook

January 17, 2014

For equity investors, 2013 was a great year for stocks, following a good year in 2012.  The table below shows historical annualized returns: 

U.S. large company stocks increased in value by 32%, and small company stocks did even better, boosted by the continuing recovery of the economy.  Developed market stocks also had a solid year, increasing in value by 23%.  The same was not true for emerging market stocks, as they fell by 2%, demonstrating the risk of this segment of the market (however, emerging market stocks have provided the highest returns over the past 10 years).  As we mentioned last year, the bull market for bonds is over – the announcements of the tapering of the bond buying program caused bond values, particularly those of Treasury bonds, to fall.

 

Economic Outlook

As was the case at the beginning of last year, the current economic data is very positive.  The unemployment rate has been continuing its steady decline since the recession and is now at 6.7%.  Gross Domestic Product (GDP) growth has been moderate and steady.  Inflation has been well below 2% - a consistent level we have not seen in over 50 years.  There are other favorable signs for the economy:

  1. Reduced Use of Leverage – Individual and corporate debt ratios are low and continuing to decline. This means less financial stress and lower delinquency rates for consumer and corporate debt.  Even the U.S. government budget deficit as a proportion to GDP has been in decline since the recession

  2. Domestic Energy Production – Net imports of energy as a proportion of total consumption have continued to decline over the past 10 years.  Part of the reason is the development of shale gas in the U.S., which has caused an economic boom in some regions and has led to relatively cheap prices for natural gas in the U.S.

  3. Consumer confidence (measured by the Consumer Sentiment Index by the University of Michigan) is at its highest level since the recession.

Stock Market Outlook

The specific stock market data are also promising.  U.S. corporate earnings are at their highest level ever.  Profit margins (operating earnings divided by sales) are also at an all-time high (nearly double the level they were 20 years ago). And stock market volatility over the past two years has been consistently low – there has been little bad news in the capital markets.  While not as favorable as the U.S. market, the broad world outlook is also somewhat positive.  The worries about a widespread economic crisis in Europe have faded, and there is an expectation of slow economic growth overseas.

 

However, there are a few concerns about the U.S. stock market:

  • Stuff Happens – This is always a concern; we don’t know what we don’t know.  Most large market declines come from unforeseen events.

  • Tapering – In 2014 the fed will be tapering the amount of fiscal stimulus it provides to the economy.  The first announcement of this back in April sent shockwaves through both the bond and stock markets.  The announcement in December of the imminence of tapering triggered a positive response from the equity markets.  However, we will be entering uncharted waters, which will likely add to the volatility of the market.

  • Valuation – As we have frequently noted over the past few years, the price-to-earnings ratio for U.S. stocks has recently been below its historical average.  It is now currently slightly above that historical average.  This means we would expect returns on stocks over the next several years to be much closer to the long-term average of 10% than the recent five-year average of 18%.  It also means there is more likely to be higher volatility in the stock market than the relatively low levels of the past two years.

Bond Market

Last year we described the bond market as “troubling.”  The bad news is we were correct – on average, bonds declined in value.  The good news is because of that decline, we are less concerned about bonds as of today.  The yield on five-year Treasury bonds is 1.75%, up from 0.72% a year ago.  That means the artificially low level of Treasury yields (and the artificially high level of bond prices) is less out of whack with the rest of the capital market than it was.  It also means that there is some more yield cushion to provide some return if interest rates rise again.  However, we still recommend that investors diversify much of their portfolio away from Treasury bonds and indexed bond funds, and include other types of bonds such as investment grade corporate, high yield, and emerging market debt. 

 

The Bubble about the Bubble

Over the past couple of months, there have been several articles in the popular press warning about the potential of a bubble in the stock market.  There are analysts who continually claiming the market on the verge of chaos (we call them “turbo-bears”), and the press occasionally cites their “research” as evidence of a bubble – despite the fact that they have been consistently wrong for the past five years.  We have seen bubbles in the recent past – internet stocks in 1999, real estate in 2007, and gold as recently as last year.  There are a few things about bubbles we know – prices are based solely on highly optimistic projections for the future, historical methods of assessing value do not justify the current valuations, and most importantly, no one following the market is calling it a bubble (because if they were, they wouldn’t recommend buying).  None of those things are in play for the stock market today.  While there is always the potential of a short-term decline in market values, the only bubble that we see is the bubble in financial reporters talking about a bubble.

 

Summary

To summarize, we have come through a good year of economic recovery and a great year for investing in stocks.  We currently have a stable U.S. stock market, with average prices relative to earnings, and reasonable growth prospects.  The situation in Europe has settled, and there is good potential for growth in emerging markets.  Bonds, while providing desired stability and diversification attributes, will likely be providing modest returns in the future.  While we believe there will be more modest stock market returns in the future than we had in the recent past, we feel very comfortable recommending balanced portfolios including an appropriate portion of equities.

 

 

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