For me, the final month of the year has always been a time to reflect upon the past as well as plan for the future. Analyzing the year soon to pass provides a valuable perspective with which to evaluate the important issues that will impact our country and economy going forward. In this context, 2013 sure has been a memorable year highlighted by horrific natural disasters, the deaths of Margaret Thatcher and Nelson Mandela, and on the lighter side, the unforgettable ending to perhaps the greatest Iron Bowl ever played.
From a market perspective, 2013 was no less historic with the Dow Jones Industrial Average as well as the S&P 500 hitting all-time highs. The tech-heavy NASDAQ was the only major index not to achieve an all-time high during the year. Despite these exciting headlines, there is reason to be a bit cautious going into the New Year. Over the past four years the stock market has appreciated 60%, while the Price/Earnings ratio has increased 45%. Essentially, the vast majority of the gain in stock prices has come from PE multiple expansion instead of earnings growth. This revaluation upward has been driven by zero interest rate policy (ZIRP) by the Fed. After years of money flowing into bonds, the tide seems to be turning in the favor of stocks over bonds. Although this could continue next year, it is a warning signal that the rally in stocks may be approaching its later stages.
How long will the Fed continue its quantitative easing in order to keep interest rates extraordinarily low? And beyond that, should they taper their bond purchases, what would happen to stock prices? If economic momentum continues the Fed will have room to gradually pull back on its quantitative easing, but if done too soon, and the economy falters, stocks would likely decline. While difficult to time, the odds favor rising rates at some point in 2014. Whether stocks can tolerate higher rates depends on the relative strength of the economy.
An economy on the upswing?… The most recent employment report offered hope that the economy is improving, with strong job gains and unemployment falling to 7.0%. If this trend continues, the odds will increase that the Fed will taper its bond purchases sooner rather than later. Yet it is far from clear that the overall economy will accelerate enough to support continued improvement in employment. The economy has not fully absorbed the recent tax increases or the complete implementation of Obamacare. Both of these forces, along with excessive litigation, regulation, and compliance, from the ever-expanding federal government, will continue to suppress economic growth. In essence, accommodative monetary policy by the Fed is offsetting the negative impacts of fiscal policy as it relates to economic growth. Again, this delicate balance worked in 2013, but there is no guarantee it will next year. Leadership change at the Fed and interim election partisanship add to already heightened political uncertainty. It may not be fun to contemplate, but it is the world we live in.
From a stock perspective, 2014 will be further impacted by three trends: Narrow stock market leadership, valuation-driven rotations between industries and sectors, and volatile overall moves driven by exogenous and unpredictable global events.
First, a persistent slow growth environment will force companies to slug it out with competitors in a battle for above average earnings growth. Those that do will be handsomely rewarded with soaring P/E ratios, a scarcity premium not unlike the valuation of rare, precious gems. Ownership of these companies will greatly enhance performance, but vigilance will be required in terms of monitoring the fundamentals because any stumble will likely cause a mad dash for the exits.
Second, in an overall market that is likely to be somewhat challenged, there will be rotations between industries and sectors as portfolio managers search for relative value. Employing disciplined valuation parameters will be essential to maintaining an optimal relative weighting in each key sector as these rotations occur throughout the year. In addition, relative weighting limits are important to utilize, which we in fact do to monitor the overall risk to equity portfolios. Specifically, in our core equity portfolio we maintain exposure to the seven major sectors between 50% and 150% of their respective weight in the S&P. The current S&P sector weights include: Technology 18%, Financials 16%, Health Care 13%, Consumer Discretionary 12%, Industrials 11%, Energy 10% and Consumer Staples 10%.
Third, as the U.S. retreats from the world stage, global tensions are escalating in the Middle East and in Asia. Russia appears to be stepping into our role and this transition makes the world potentially more volatile, in my view. Confrontations or unanticipated political events in either region could roil markets around the world. Like it or not, it is the world we live in.
Closer to home, 2013 was a year for which we at Willingdon have much to be thankful for. Three outstanding professionals joined our team, pushing our first string to a grand total of eleven. In a couple months we will be moving into a new office in the Huntersville Business Park. Most of all we are thankful for our wonderful and loyal clients, spread out across twenty-six states.
Merry Christmas and God bless everyone. After all, it is His world we live in.