2013 exceeded the expectations of even the most optimistic of stock market prognosticators.  To the utter dis-belief of the perennial skeptics, common stocks hit new all-time highs this past year with the Dow Jones Industrial Average blowing past 16,000 and the S&P 500 scaling 1,800.   Posting the best annual returns in 16 years, stocks once again demonstrated their total unpredictability.  Closing at 1,848 the S&P 500 finished the year up 170% from its March, 2009 low (excluding dividends).  

How was this stellar performance even possible given all the negatives such as the Syrian crisis, a government shutdown, a botched on-line implementation of the Affordable Care Act (Obama Care) and fear of higher interest rates should the Federal Reserve relax monetary policy?  It’s because markets often focus on what really matters, and what really matters is fundamentals. 

We are now well into the fifth year of an economic recovery which began in June, 2009.  This rebound has been modest by comparison but it seems to be picking up steam.  Additionally, when compared with alternative investments such as low-yielding bonds, illiquid real estate or volatile precious metals, ownership in great publicly traded companies, many of which pay hearty dividends, looks pretty attractive.  It’s no wonder investors bid up share prices throughout the year as companies continued to post ever-increasing earnings gains.  Along with higher earnings came increased dividends, share buy-backs and/or debt retirement strategies, all designed to enhance shareholder value. 

Real gross domestic product (GDP) grew at an impressive 4.1% rate in the third quarter, above the earlier 3.6% estimate and much stronger than the 2.5% rate reported for the second quarter.  The housing market is in recovery and inflation has been running well within the Fed’s target range.  This is the type data the Federal Reserve considered in its recent decision to start throttling back on its $85billion monthly purchases of mortgages and US Treasury debt, a process known as QE or Quantitative Easing.  Bears argued this easing up on the monetary accelerator would increase interest rates (it did) and result in a major sell-off in stocks (it didn’t).  Bulls found reassurance in the Fed’s decision since it really means the outlook for our economy is such that we may need less and less government intervention to keep it chugging along. 

Fourth Quarter Numbers 

The U.S. stock market was the place to be in 2013; and the smaller, the better.  Large companies as measured by the S&P 500 gained x% in the 4th quarter and y% for the full year.  But small companies (S&P 600) won bragging rights, up x% in the period and a staggering x% for the year.  International companies’ performance varied greatly as developed countries (MSCI-EAFE Index) gained 5.25% & 19.30% respectively for the quarter and the year.  The 21-country emerging markets returns were less impressive at 1.46% and –5.05% for 4Q-13 & 2013 respectively.  Why not just throw in the towel on emerging markets?  If there is one thing we know for certain, it’s that no one can consistently predict the next winner in the stock market.  Too many times we’ve witnessed last year’s ugly duckling turn into next year’s swan.   Those emerging market countries may be struggling now, but they will turn around and when they do it will be too late to invest.   

Interest rates rose in response to FOMC policy, resulting in modest returns for shorter bonds and losses for longer bonds. The10-year Treasury hit a 2013 high of 3.02%; almost double the year’s low of 1.62%, but it is still half its average of 6.07% in the two decades before the financial crisis.   Short-intermediate bonds (Barclay’s 1-5 Year Government/Credit) returned x% for 4Q-13 and y% for the year.  Longer bonds, such as the 10 and 30-year US Treasury, suffered losses of X% & Y% for 4Q-13 and X% & Y% for the year.  Given that most investors cannot tolerate the volatility of an all-stock portfolio, we continue to utilize short-term bonds to temper volatility, provide modest income and primary liquidity.   We think investors should avoid longer-term maturities since they typically fall the most with a rise in interest rates.  

Precious metals investors suffered huge losses as gold and silver fell x% & y% during the quarter and x% & y% for the year.  The irony is that those investing in this sector were seeking shelter from a purchasing power decline they think is inevitable. Many believe the continued increase in U.S. debt will lead to a falling dollar and runaway inflation.  The rest of the world obviously thinks Uncle Sam is still a safe bet as evidenced by the low interest rates at which borrowers are willing to lend to the U.S. Treasury.   

Even those so-called “sophisticated” hedge fund managers failed for the X consecutive year to keep pace with a low-cost, broadly diversified index of common stocks.  Hedge fund investors are learning the hard way that illiquidity and high fees can be a steep price to pay for “intellectual capital” that consistently under-performs.   

What’s Next?  

Keep an eye on corporate profits, inflation and interest rates.  The Federal Reserve will look for evidence of a sustained recovery combined with tame inflation to continue reducing its quantitative easing.  As it does so, interest rates are expected to rise (something for which we are prepared).  With the S&P 500 trading at 15 times 2014’s estimated earnings of $122, stocks certainly have upside potential. 

After a year like 2013, it’s easy to become overconfident and increase your allocation to stocks.  That can be a mistake.   Markets rarely go straight up without correcting.  Our experience with numerous investors over many years, in many types of markets reveals that a person’s perceived risk tolerance is often related to their most recent risk-based experiences.  Your exposure to equities should be the result of a formal Asset Allocation Policy which considers a number of variables including your goals and objectives, time horizon, current and future resources and ability to bear risk.  Rather than just pick a number that seems good today, we prefer to utilize a more objective process which considers those factors and the historical risk and return characteristics of the capital markets.  We can then recommend a policy that’s based on fundamentals not intuition. 

Stick to your plan if you have one.  If you don’t, we are ready, willing and able to help you create one.  We believe prudent planning is just as important as professional asset management.  Part of our mission is to help you achieve your goals with a reasonable probability of success, at reduced costs and without unneeded risk.  That requires planning, execution and constant re-evaluation.  Successful investing is not complicated, but there is nothing easy about it.