1Q 2014 Commentary
by Richard Siegel, CFP®
If one were to look at the returns of the capital markets for the first quarter of 2014, the word “unremarkable” might come to mind. Global equities returned a benign .9%, while bonds fared better with a 1.8% return. However, these year-to-date returns do not tell the whole story; the path to these returns was fairly volatile. As we mentioned at the end of 2013, investors should brace themselves for increased volatility in both the equity and fixed income markets. After a year like 2013, when equity markets went straight up without any major hiccups, it is easy to become complacent. More typically, the equity markets have a 10%+ pullback once per year. Stocks have not seen this type of correction since the summer/fall of 2011. Additionally, bond prices are susceptible to movements in interest rates. With a wide array of economic data and a shift in monetary policy, we expect interest rates to continue gyrating with an upward bias.
Arriving at these returns was actually more volatile than it first appears….
Much of our methodology is driven by fundamental research and metrics. It has become increasingly more difficult to find real value in either the stock or bond market. Last year can be considered a “beta” year meaning that the more risk you took on, the higher your return. This year can be considered an “alpha” year meaning that investors will be rewarded by taking risk in areas that make sense, while avoiding or underweighting areas that represent pitfalls.
For the quarter, both the U.S. and foreign equity markets delivered flat returns. This is actually healthy and serves to balance out the above average returns of 2013. It appears that markets are digesting the various economic data points and current events.
It is our contention that the stock market is in the middle stages of a long-term secular bull market. This thesis is based on the following set of observations and data:
- Innovation: U.S. energy revolution, cloud computing, tablets and hand held devices, 3D printing
- Corporate earnings are still growing, not contracting.
- Fed is still accommodative: low interest rates and ready to stimulate if data falters
- Improving economic backdrop: unemployment, GDP growth, manufacturing, housing and autos
- The yield curve remains steep. Short term yields are at 0% while the 30 year Treasury yields
3.56%. Typically, there would be a flat or inverted yield curve if we were entering a recessionary
- There is still a general lack of exuberance about the stock market from the investing public.
- The forward PE ratio on the S&P 500 is 15.571. This is not the kind of multiple we
see at the peak of a bull market. During the technology bubble in 1999/2000, PE’s were in the
high 30’s, more than twice as expensive as stocks are today.
To expand on the last bullet point, not all equities are priced the same. In fact, certain sectors of the stock market are quite expensive. U.S. small cap stocks have outperformed large caps over the last several years and are currently sitting at a 19.052 forward PE ratio, which is above its historical norm. Our portfolio strategies are heavily biased toward high quality large/mid cap companies with rock solid balance sheets. We have made a concerted effort to avoid the more volatile, expensive areas of the equity markets.
Fixed Income Overview
Bonds were a bright spot for our client portfolios this quarter. Due to the volatility in the equity markets, mixed economic data, and the Russia/Ukraine tensions, rates pulled back slightly pushing bond prices upward. The 10-year Treasury rate is still much higher than last year at this time, but is temporarily range bound in the 2.60 – 3.00% range. We expect rates to eventually pierce through the 3.00% level based on economic growth, inflation, and the Fed’s easing of its bond buying program.
Operating under the assumption that interest rates will grind higher over the long run, we remain fairly cautious within the fixed income component of our strategies. An average duration of approximately 3 years and a credit quality in the BBB range provides a level of protection against interest rate volatility, with a respectable yield and a hedge against the stock market.
During the quarter, Fed Chair Janet Yellen, insinuated that once the Fed’s large scale asset buying program is wrapped up, we should expect that short-term rates will be increased shortly after. The positive view is that cash would no longer be yielding almost nothing, and that the economy would be strong enough on its own without artificial stimulus. The downside may be that as the money supply becomes tighter, economic activity could slow. This is most certainly a dynamic that we plan to watch very closely.
To reiterate, we expect volatility to continue in both the equity and fixed income markets. As always, we manage portfolios to participate in the long term growth of capital markets while reducing risk and volatility. Ultimately, the goal of this strategy is that our clients remain comfortable being invested and building wealth using our prudent investment methodology.