Market Insight - January 2014
This was a very rewarding year for the financial markets, and our clients as well. Since 2009, despite fiscal paralysis, volatile markets and a very tentative economic recovery, investors have come to see the U.S. economy as not only a viable, but perhaps the best environment, in which to build real, sustainable wealth for themselves and their families.
However, good returns inevitably reinforce positive expectations for the future. Those expectations can distort our ability to see and process objectively, as we seek to develop an investment philosophy for a global economy that is transforming itself, at a sometimes dizzying pace, into something very different from what we have become used to.
It’s been a very good year, but we’re ready to move on.
Our focus now should be on earnings growth expectations and Fed policy, especially as reflected by the market in medium and long-term interest rates. These are the factors that will have the most impact on portfolio returns. The yield on the ten year government bond touched 3% in December, up from 1.6% mid-year. This extraordinary rise has, for the most part, discounted the effect of the taper on benchmark rates, at least through 2015. We expect that the effect of higher rates on the stock market will be subdued, and not represent a meaningful impediment to long term gains. The ten year bond return of nearly 3%, we think, represents good value for fixed income investors. For tax free investors, these levels are even more compelling. Triple A rated ten year South Carolina municipal bonds, free of both federal and state tax, are currently yielding 2.77%, equivalent to a 4.26% taxable return for investors in the 28% tax bracket. Despite much media hype, we see no reason to be fearful of bonds. In fact, fixed income investors in balanced portfolios have several avenues of opportunity to follow that would allow them to benefit from an expanding economy and higher yields. One of the strategies we are implementing, investing in laddered maturities of highly rated corporate bonds, will provide safety of principal as well as capital for reinvestment at specified future dates, when rates may be higher. We are also using bond funds and their reinvestment capabilities for sectors in the market where diversification is key to safety; for instance, lower-rated bonds, emerging market debt, and government bonds outside the US. Fixed income investors who hit the panic button in 2013 when rates jumped did themselves little good, and for the most part, just lost interest income.
It may seem counterintuitive, but unusually good investment returns generate feelings of anxiety and unease for many investors, leading them to become overly fearful of the future, and easy prey to the notion that markets are in a bloated speculative bubble, ready at any moment to burst.
Others, charged up by the equity market’s recent gains, are ready to embrace a new, super bull market. While discounting these emotional extremes, there are some signs calling for caution, even though we are very positive for returns going forward. Investors’ sentiment has been getting stronger, and that’s typically a contrarian indicator. The budget deficit, while shrinking, has ballooned in the last decade, as has debt as a percentage of GDP. Our economy has become increasingly polarized, and while financial and real estate investors have seen a strong recovery, for many, a return to prosperity seems far from certain. Over 11 million Americans are still unemployed, twice as many as in 2000, and the rate of unemployment remains stubbornly high.
Still, while the US stock market is hardly the bargain it was 12-18 months ago, the foundations of share price growth are still strong. Price earnings ratios remain reasonable, inflation is low (perhaps too low,) and innovation is accelerating in technology and energy. Corporate investment is muted now, but remains a potent driver of future returns. Perhaps most important, under new Chairman Janet Yellen, the Fed’s policy of economic stimulus remains intact, and an orderly taper of QE3 seems likely. We believe that you don’t fight the Fed.
Our investment discipline calls now for moderation, and rebalancing of stock allocations in the face of strong markets, both to secure gains, and to keep funds in reserve for buying when the markets correct. Knowing which asset classes have underperformed, and why, will generally suggest opportunities. For example, returns in emerging markets, for good reasons, lagged significantly last year. Yet the long term secular rate of GDP growth in emerging markets is still intact; investing there is now cheaper, and potentially more rewarding for our clients. Consequently, our international mix will tilt more in favor of this asset class as we move forward.
While we are confident things will end well this year, higher valuations and inevitable earnings disappointments are likely to cause some pretty steep corrections in 2014, in the 8-13% range. They will be accompanied by much gnashing of teeth and dire predictions, and some investors, understandably fearful, will find their resolution begin to waver. After all, some corrections really do turn into bear markets. Despite some turbulence, we don’t believe that will be the case in 2014. Moreover, we think that greater volatility in the year ahead will present our clients with buying opportunities in both stocks and bonds that will enhance returns in the long run.